Lenders want to reduce risk as much as possible. One of the methods they use to demonstrate that an applicant is good to lend to is through the debt ratio formula.
In this article we will cover the following topics:
- What is the debt ratio?
- Why Debt Ratio Matters?
- What is the Debt Ratio Formula?
- Analysis of Debt Ratios
- Risk of Low Debt Ratio
- Leveraging Financial Strength
- Debt Ratio and Interest Rates
- What is the Difference Between the Debt Ratio and the Long-Term Debt to Asset Ratio?
- Final Thoughts
What is the debt ratio?
Debt ratio is a type of financial ratio that can be used to describe the level of a firm’s leverage. Debt ratio is also known as debt to total asset ratio or debt to asset ratio. The debt ratio of a company measures its financial health and it determines whether it can pay its liabilities with its assets.
Usually, lenders and investors use the financial statements of a company to calculate its debt ratio to measure its financial leverage and its ability to meet the debt obligation in the future. It gives insight into how company assets are financed— either through debt, equity, or a combination of both.
If the level of liability is high compared to assets, then the company is considered highly leveraged. This is because the business tends to finance its operations and assets through debt. Such a company is riskier for creditors and investors and may struggle to borrow money.
Why Debt Ratio Matters?
Most people wonder what debt ratios are and why they matter. The debt ratio measures the degree of leverage of a company and this is used by investors and lenders to measure risk. It helps lenders to estimate the level of lending risk that they will incur when they give corporate finance to companies and organizations.
When applying for loans, most lenders will want to know what the debt ratios for your business are. Every lender wants to give credit to a company with a low debt ratio, as this shows that their overall debt burden is low. A low-risk debt ratio also means that the business is more independent and doesn’t only rely on borrowed funds. However, a high debt ratio shows that the company will go out of operation should the creditors require full repayment of the debt.
Debt ratios are also important to investors as it helps them determine the financial leverage of a business before they can make any investments. When a business provides for its assets through debt, creditors consider the business as credit risky and investors tend to shy away. Basically, the higher the debt ratio the greater the financial leverage and risk of a company. When investors buy businesses with a high ratio, it means that they may take on more debt. This can lead to more challenges for investors in the future.
What is the Debt Ratio Formula?
The debt ratio of a company is calculated by total liabilities divided by the total assets. It’s important to note that the debt comprises both short term and long-term liabilities while the total assets include the company’s intangible, current, and fixed assets. The formula is:
Debt Ratio = Total Liabilities / Total Assets
Higher debt ratios show that the company financing to pay off assets is from debt rather than equity, and this is a risky financial approach. On the other hand, a lower debt ratio implies that the company financing comes from equity and not debt. Creditors, investors, and lenders are more likely to lend to borrowers with low debt ratios because they have a higher ability to pay off in the future.
Analysis of Debt Ratios
The debt ratio is an important financial ratio to lenders and creditors. Basically, different lenders set their own debt ratio limits that they use to determine whether a company has good financial health. Ratio analysis also gives them insight into the company’s ability to repay the debt in full.
A debt ratio (0.5 or lower) is considered a good debt since it shows that the company’s assets are financed via equity. In simple terms, a company with a debt ratio of 0.5 has assets that are twice as much as the liabilities. 50 percent of the company’s assets are owned by the shareholders while the other 50 percent are owned by creditors. If the company decided to sell all its assets, they would have enough to pay off the debt and remain with a good amount of money.
A debt ratio of 0.6 or higher is considered a high debt ratio, and such companies are considered highly leveraged. A debt ratio above 1.0 implies that the company in question has more debts than assets. To pay off their liabilities, the company would have to sell all its assets, and they would be left with nothing, leading to bankruptcy. Such companies are risky for potential investors.
Company ABC is considering borrowing money from the local bank. The bank then looks at the company’s financial statement to determine what are the debt ratios of the company. The bank finds out that the company has total assets of $100,000 as well as debt outstanding of $25,000 on its balance sheet. To find the company’s debt ratio, we divide the total liabilities by the total assets:
Debt ratio = $25,000/ $100,000
The low debt ratio shows that most of company ABC’s assets are provided through equity and only 25 percent are financed through debt. It is, therefore, easier for this company to borrow money.
Risks of Low Debt Ratio
Although low credit shows a company’s creditworthiness, there are risks associated with having very little debt. Some investors shy away from purchasing stock from companies with very low debt ratio. This is because firms with very low debt ratio do not consider borrowing as an option to finance and expand their operations. As a result, they may not bring in as many returns as investors would want. You might want to take this into consideration if you want investors to purchase stock in your firm.
Leveraging Financial Strength
It is also important to note that different industries have varying debt ratios. The type of industry also affects how the debt will be used. For instance, businesses in the capital-intensive industry such as pipelines, manufacturing, and utilities have higher debt ratios compared to those in the technology sector and other industries.
This means that a company in the sector of pipeline or utility with stable cash flows can be able to manage when it has more debts than assets. Because a high debt ratio is a norm for such an industry, they are more likely to get away with high indebtedness than other sectors. Therefore, when calculating the optimal debt ratio of a company, it is paramount to consider the industry and do a comparison with the competitors.
The other thing that can be used to determine whether a company is in a good financial situation is the company’s cash flow. Large companies can leverage financial strength because they tend to have more stable cash flows than smaller companies. Also, businesses in monopoly and oligopoly are subject to reliable and steady cash flows and can repay the loan in a reliable manner.
Conversely, smaller businesses are subject to unpredictable cash flow because of rapid product cycles and constant competition. Because of their volatile cash flows, smaller businesses may find a debt level of 30% to be too high, something that can be manageable for companies with stable cash flows. Thus, companies in industries that experience unstable cash flow should maintain a low ratio of total debt.
Debt Ratio and Interest Rates
Whether a debt ratio is good or not will also depend on the current interest rate. Debt ratios are prone to interest rate risk. Essentially, when the interest rates are high, good debts are relatively lower than when the interest rates are low.
A company that has a high debt ratio has more debts, and this command a significant amount of the company’s cash flow in terms of principal and interest rate payments. Consequently, the company is likely to default in making payments when the interest rate increases.
Conversely, a low debt ratio shows that the company’s assets are more than its debts. Such a company is not very sensitive to changes in interest rates. For this reason, the principle and interest payment won’t take much of the company’s cash flow. A slowdown in the financial performance won’t necessarily lead to a default in debt payment. It is therefore important that the risk of debt ratio be analyzed on a company-to-company basis.
What Is the Difference Between Debt Ratio and Long-Term Debt to Asset Ratio?
The Debt ratio which is calculated as total debts divided by total assets considers both long-term debts like mortgages and short-term debts like, loans, lines of credit, and rent. On the other hand, the long-term debt to asset ratio is calculated by including only long-term debts like securities and mortgages.
Nonetheless, both ratios include all the assets of a business, including tangible assets like property, inventory and equipment as well as intangible assets like goodwill, and accounts receivable. All the same, the debt ratio is likely to be higher than the long term debt to assets ratio because it compromises more of the company’s liabilities.
Final Thoughts on What are Debt Ratios?
If you are managing your own company, you need to diligently keep records of your financial businesses. This will help you estimate your business’ debt ratio so that you can avoid being in a risky financial structure.
With a low debt ratio, creditors will approve your loan application and investors will not shy from buying your business. You can also take advantage of accounting and invoicing software like Debtor to track your assets so that you know what are debt ratios for your company.
Meet Maurice, a staff editor at Bigger Investing. He’s an accomplished entrepreneur who owns multiple successful websites and a thriving merch shop. When he’s not busy with work, Maurice indulges in his passion for kayaking, climbing, and his family. As a savvy investor, Maurice loves putting his money to work and seeking out new opportunities. With his expertise and passion for finance, he’s dedicated to helping readers achieve their financial goals through Bigger Investing.