Debt ratio (also known as debt to assets ratio) is a ratio which measures debt level of a business as a percentage of its total assets. It is calculated by dividing total debt of a business by its total assets.
Debt ratio finds out the percentage of total assets that are financed by debt and helps in assessing whether it is sustainable or not. If the percentage is too high, it might indicate that it is too difficult for the business to pay off its debts and continue operations.
Debt ratio is calculated using the following formula:
|Debt Ratio =||Total Debt|
Total debt equals long-term debt and short-term debt. It is not equivalent to total liabilities because it excludes non-debt liabilities such as accounts payable, salaries payable, etc.
Total assets include both current assets and non-current assets.
Sometimes, debt ratio is calculated based on the total liabilities instead of total debt.
Debt ratio is a measure of a business’s financial risk, the risk that the business’ total assets may not be sufficient to pay off its debts and interest thereon. Since not being able to pay off debts and interest payments may result in a business being wound up, debt ratio is a critical indicator of long-term financial sustainability of a business.
While a very low debt ratio is good in the sense that the company’s assets are sufficient to meet its obligations, it may indicate underutilization of a major source of finance which may result in restricted growth. A very high debt ratio indicates high risk for both debt-holders and equity investors. Due to the high risk, the company may not be able to obtain finance at good terms or may not be able to raise any more money at all.
Businesses set their target debt ratio based on their target capital structure. It involves trade-off between the financial risk and growth.
Debt ratio is very industry-specific ratio. It should be analyzed in comparison with competitors and together with other ratios such as times interest earned [http://accountingexplained.com/financial/ratios/times-interest-earned], etc.
Example 1: Calculate debt ratio for PQR, Inc. based on the information given below:
Total assets = $500,000 + $845,000 = $1,345,000
Total debt = $340,000 + ($270,000 – $20,000) = $590,000
Please note that we excluded accounts payable from total liabilities because it is not debt.
|Debt Ratio =||$590,000||= 0.44|
Example 2: Analyze solvency of JPM, WFC, TGT and DG based on debt ratio values obtained form Morningstar for 2011, 2012, 2013 and 2014.
This example illustrates the fact that ratio analysis is useful when used to analyze companies within the same industry.
JPM & WFC both are financial services companies and hence competitors and their debt ratios for the four years are remarkably different than the debt ratios of TGT and DG, which are retailers.
WFC has better debt ratios than JPM in all the four years except the most recent financial year. However, the difference is negligible. The ratio for both firms has stayed in a narrow range of 13-15% over the four-year period indicating little change in solvency of the companies.
The difference between debt ratios is more pronounced in case of TGT and DG. DG has better debt ratio in all the four years and that too by a significant margin. DG debt ratio has improved over the four years from 27.03% to 23.52%. In case of TGT, there is improvement in 2011-2014 followed by escalation in 2014.
Written by Irfanullah Jan