Debt ratio is defined as the sum of a company’s long term and short term debt divided by it’s total assets. This ratio is then expressed as a percentage. It gives us an indication of what percentage of a company’s assets are financed by debt. The formula looks like this:
When most of the company’s assets are financed through equity the debt ratio will be less than 50%. Alternately, if the company’s assets are largely financed through debt, the debt ratio will be greater than 50%.
A lower debt ratio implies that the company is more stable and could enjoy longevity. A higher debt ratio could be an indicator that debt could be hard to service. A higher debt ratio will be a red flag to a banker who might be considering loaning money to the company.
Calculate the debt ratio for a company using the following data:
Total assets = $600,000 + $825,000 = $1,425,000
Total debt = $340,000 + $270,000 = $610,000
Debt ratios, like many financial ratios, will vary from one industry to another. Some industries require more borrowing to maintain a successful operation. Other industries with high cash flows tend to do fine with less borrowing. It pays to know industry average debt ratios when examining a specific company’s performance.
Capital intensive companies that require purchasing much heavy equipment will likely have a higher debt ratio. Examples could be mining operations, railway companies, and utility companies. Other companies requiring less borrowing will have lower debt ratios. Software companies and some service industry companies sell their goods and services without heavy capital investment. Their debt ratios will likely be lower.