Debt Ratio Definition

Buy Limit Order Definition and Example

What is a debt ratio?

The debt ratio is a financial ratio that measures the magnitude of a company’s leverage. The debt ratio is defined as the ratio of total debt to total assets, expressed in decimals or as a percentage. It can be interpreted as the proportion of assets in a debt-funded enterprise.

A ratio greater than 1 shows that a considerable part of the debt is financed by assets. In other words, the business has more liabilities than assets. A high ratio also indicates that a business could be exposed to the risk of defaulting on its loans if interest rates suddenly increased. A ratio of less than 1 means that more of the assets of a company are financed by equity.

The debt ratio is also called the debt-to-asset ratio.

The debt ratio formula is

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What does the debt ratio tell you?

The higher the debt ratio, the more the company is in debt, which implies an increased financial risk. At the same time, leverage is an important tool that businesses use to grow, and many businesses are finding sustainable uses of debt.

Debt ratios vary widely from industry to industry, with capital intensive firms such as utilities and pipelines having much higher debt ratios than other industries such as the capital sector. technology. For example, if a business has total assets of $ 100 million and total debt of $ 30 million, its debt ratio is 30% or 0.30. Is this company in a better financial situation than a company with a debt ratio of 40%? The answer depends on the industry.

A debt ratio of 30% may be too high for an industry with volatile cash flows, in which most companies do not get much debt. A company with a high debt ratio compared to its peers would probably find it expensive to borrow and could find itself in a critical situation if circumstances changed. The hydraulic fracturing industry, for example, experienced difficult times starting in the summer of 2020 due to high debt levels and falling energy prices. Conversely, a debt level of 40% can be easily managed for a business in an industry such as utilities, where cash flows are stable and higher debt ratios are the norm.

A debt ratio greater than 1.0 (100%) tells you that a business has more debt than assets. At the same time, a debt ratio of less than 100% indicates that a company has more assets than debt. Used in conjunction with other measures of financial health, the debt ratio can help investors determine the risk level of a business.

Some sources define the debt ratio as total liabilities divided by total assets. This reflects a certain ambiguity between the terms “debt” and “liability” which depends on the circumstances. The debt ratio, for example, is closely related and more common than the debt ratio, but uses total liabilities in the numerator. In the case of the debt ratio, financial data providers calculate it using only long-term and short-term debt (including current parts of long-term debt), excluding liabilities such as accounts payable, negative goodwill and “others”.

In the consumer and mortgage loan industry, two common debt ratios used to assess a borrower’s ability to repay a loan or mortgage are the gross debt service ratio and the debt service ratio. total debt. The gross debt ratio is defined as the ratio of monthly costs of housing (including mortgage payments, home insurance and real estate costs) to monthly income, while the ratio of total debt service is the ratio of monthly housing costs plus other debts such as car payments and credit card loans to monthly income. Acceptable levels of the total debt service ratio, in percentage terms, range from the mid-1930s to the low 40s.

Key points to remember

  • The debt ratio is a financial ratio that measures the magnitude of a company’s leverage in terms of total debt relative to total assets.
  • A debt ratio greater than 1.0 (100%) tells you that a business has more debt than assets. At the same time, a debt ratio of less than 100% indicates that a company has more assets than debt.
  • Debt ratios vary widely from industry to industry, with capital intensive firms such as utilities and pipelines having much higher debt ratios than other industries such as the capital sector. technology.

Examples of debt ratio

Let’s look at some examples from different industries to contextualize the debt ratio. Starbucks Corp. (SBUX) recorded $ 0 in short-term and short-term portion of long-term debt in its balance sheet for the year ended October 1, 2020 and $ 3,932,600,000 in long-term debt. The company’s total assets amounted to $ 14,365,600,000. This gives us a debt ratio of $ 3,932,600,000 ÷ 14,365 6,500,000 $ = 0.2738, or 27.38%.

To assess whether this figure is high, we must take into account the capital costs incurred to open a Starbucks: rent a commercial space, renovate it to adapt it to a certain configuration and buy expensive specialized equipment, much of which is rarely used. The company must also hire and train employees in an industry with exceptionally high staff turnover, comply with food safety regulations, etc. for more than 24,000 sites in 75 countries. Maybe 27% isn’t that bad after all, and Morningstar indeed gives the industry average at 40%. The result is that Starbucks finds it difficult to borrow money; creditors are satisfied that she is in a solid financial position and can be expected to repay them in full.

And a technology company? For the year ended December 31, 2020, Facebook Inc. (FB) declared its short-term and current portion of long-term debt at $ 280,000,000; its long-term debt was $ 5,767,000,000; his total assets were $ 64,961,000,000. Facebook’s debt ratio can be calculated as follows: ($ 280,000,000 + $ 5,767,000,000) ÷ $ 64,961,000,000 = 0.0931, or 9.31%. Facebook does not borrow in the corporate bond market. He has enough time to raise capital through actions.

Finally, let’s look at a basic materials company, the miner Coal Coal Inc. (ARCH) from St. Louis. For the year ended December 31, 2020, the company posted short-term and short-term portions of $ 11,038,000, long-term debt of $ 351,841,000 and total assets of $ 2,136,597,000. Coal mining is extremely capital intensive, so that the industry forgives the leverage effect: the average debt ratio is 47%. Even in this cohort, Arch Coal’s debt ratio of ($ 11,038,000 + $ 351,841,000) ÷ $ 2,136,597,000 = 16.98% is much lower than the average.

The difference between the debt ratio and the long-term debt ratio

While the total debt / total assets ratio includes all debts, the long-term debt / assets ratio only takes into account long-term debts. The measurement of the debt ratio (total debt to assets) takes into account both long-term debts, such as mortgages and securities, and current or short-term debts such as rents, utilities and loans maturing in less than 12 months. However, both ratios include all of the assets of a business, including tangible assets such as equipment and inventory and intangible assets such as accounts receivable. Since the total debt / asset ratio includes more of a company’s liabilities, this number is almost always higher than a company’s long-term debt ratio.

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