Debt Ratio is a financial ratio that indicates the percentage of a company’s assets that are provided via debt. It measures the extent of a company’s leverage. The debt ratio is defined as the ratio of total debt to total assets, expressed as a decimal or percentage.
A ratio greater than 1 shows that a considerable portion of debt is funded by assets. In other words, the company has more liabilities than assets. A high ratio also indicates that a company may be putting itself at a risk of default on its loans if interest rates were to rise suddenly. A ratio below 1 translates to the fact that a greater portion of a company’s assets is funded by equity.
Formula
The debt ratio is calculated by dividing total liabilities by total assets. The debt ratio shows the overall debt burden of the company—not just the current debt.
What Does It Tell You?
Companies with higher levels of liabilities compared with assets are considered highly leveraged and more risky for lenders. At the same time, leverage is an important tool that companies use to grow, and many businesses find sustainable uses for debt.
This helps investors and creditors analyze the overall debt burden on the company as well as the firm’s ability to pay off the debt in future, uncertain economic times.
A lower debt ratio usually implies a more stable business with the potential of longevity because a company with lower ratio also has lower overall debt. Each industry has its own benchmarks for debt, but 0.5 is a reasonable ratio.
A debt ratio of 0.5 is often considered to be less risky. This means that the company has twice as many assets as liabilities. Or said a different way, this company’s liabilities are only 50 percent of its total assets. Essentially, only its creditors own half of the company’s assets and the shareholders own the remainder of the assets.
A ratio of 1 means that total liabilities equal total assets. In other words, the company would have to sell off all of its assets in order to pay off its liabilities. Obviously, this is a highly leveraged firm. Once its assets are sold off, the business no longer can operate.
More About Debt Ratio
Let’s look at a few examples from different industries to contextualize the debt ratio: Starbucks Corp. (SBUX) listed $0 in short-term and current portion of long-term debt on its balance sheet for the fiscal year ended October 1, 2017, and $3,932,600,000 in long-term debt. The company’s total assets were $14,365,600,000. This gives us a debt ratio of $3,932,600,000 ÷ $14,365,600,000 = 0.2738, or 27.38%.
To assess whether this is high, we should consider the capital expenditures that go into opening a Starbucks: leasing commercial space, renovating it to fit a certain layout, and purchasing expensive specialty equipment, much of which is used infrequently. The company must also hire and train employees in an industry with exceptionally high employee turnover, adhere to food safety regulations, etc. for more than 24,00 locations, in 75 countries. Perhaps 27% isn’t so bad after all, and indeed Morning Star gives the industry average as 40%. The result is that Starbucks has an easy time borrowing money; creditors trust that it is in a solid financial position and can be expected to pay them back in full.
What about a technology company? For the fiscal year ended December 31, 2016, Facebook Inc. (FB) reported its short-term and current portion of long-term debt as $280,000,000; its long-term debt was $5,767,000,000; its total assets were $64,961,000,000. Facebook’s debt ratio can be calculated as ($280,000,000 + $5,767,000,000) ÷ $64,961,000,000 = 0.0931, or 9.31%. Facebook does not borrow on the corporate bond market. It has an easy enough time raising capital through stock.
Conclusion
Finally, let’s look at a basic materials company, the St. Louis-based miner Arch Coal Inc. (ARCH). For the fiscal year ended December 31, 2016, the company posted short-term and current portions of long-term debt 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 the industry is forgiving of leverage: 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 well below average.There is a sense that all debt ratio analysis must be done on a company-by-company basis as it depends on the industrial sector whether the debt ratio is good or not. Balancing the dual risks of debt—credit risk and opportunity cost—is something that all companies must do.
