Debt Ratio: What Is It and How to Calculate It

Introduction

Running a business involves balancing various financial decisions. One crucial aspect of managing a successful company is understanding its financial structure, particularly the balance between debt and equity. This is where the debt ratio comes into play. The debt ratio measures the extent to which a company is financed by debt, providing a clear picture of its financial leverage. 

This ratio is not just a number; it’s a tool for strategic planning for both large and small companies. It helps assess financial risk, guide investment decisions, and ensure long-term sustainability.

What Is the Debt Ratio?

The debt ratio is a financial metric that indicates the proportion of a company’s resources that are financed by debt. It is calculated by dividing the company’s total liabilities by its total assets. This ratio provides insight into the company’s financial leverage and potential financial risk.

Debt Ratio Formula

The debt ratio is calculated using the following formula:

How to Calculate Debt Ratio

Calculating the debt ratio quantifies the proportion of a company’s assets that are financed by debt. To calculate it, you need to get the total debt and total assets of the company, usually from its balance sheet. Calculating the debt ratio enables stakeholders to evaluate a company’s leverage.

To calculate the debt ratio, follow these steps:

1. GetFind the balance sheet: The balance sheet is one of the key financial statements that shows a company’s financial position at a specific point in time. It lists assets, liabilities, and equity.
2. Identify total debt: Under the section labeled “Liabilities.”, check for short term debt, current portion of long term debt and long term debt, then Sum all these three together to get total debt.
3. Identify total assets: Look for the section labeled “Assets.” Total Assets include both current assets (easily converted to cash within a year) and non-current assets (long-term investments, property, etc.).
   • Current assets might include cash, accounts receivable, and inventory.
   • Non-current assets might include property, plant, equipment, and intangible assets.
4. Calculate the debt ratio: Now, Use the debt ratio formula to divide Total debt by Total Assets.

Debt Ratio Calculation Example

For example, consider a company with a total debt of $750,000 and total assets worth $2,000,000. By using the debt ratio equation, we get debt ratio equals to 0.375. A debt ratio of 0.375, indicates that 37.5% of its total assets are financed by debt, providing insight into its financial leverage.

Debt Ratio= 2,000,000 / 750,000 = 0.375 or 37.5

This means that 37.5% of the company’s assets are financed by debt, providing insight into its financial leverage and risk level.

Importance of Debt Ratio

The debt ratio is a crucial metric for evaluating a company’s leverage and overall financial health. It provides insights into how much of the company’s assets are financed by debt, which helps in assessing financial risk and stability. Key reasons why the debt ratio is important include:

1. Risk assessment:

   Debt ratioindicates the extent to which a company relies on borrowed funds, providing insights into its ability to meet debt obligations regardless of financial performance.

2. Financial health:

   This ratio helps stakeholders understand the company’s financial leverage and the balance between debt and equity financing.

3. Credit evaluation:

   Lenders and investors use the debt ratio to gauge the company’s creditworthiness and its ability to meet debt obligations.

4. Strategic planning:

   Businesses use this ratio to make informed decisions about financing operations, investments, and growth strategies.

5 Common Types Of Debt Ratio

Different types of debt ratios provide insights into different aspects of a company’s debt load and financial health. Here are the main types of debt ratios:

1. Debt-to-assets ratio

The debt-to-assets ratio measures the proportion of a company’s assets that are financed by debt. It is calculated using the formula:

Importance of debt to assets ratio

• Financial Leverage: Indicates how much of the company’s assets are funded by debt versus equity.
• Risk Assessment: A higher ratio suggests greater financial risk, as more assets are financed by debt.
• Credit Evaluation: Lenders and investors use this ratio to assess the financial stability and leverage of a company.

2. Debt-to-equity ratio

The debt-to-equity ratio compares a company’s total debt to its total equity, showing the balance between financing from creditors and investors. The formula is:

Importance of debt to equity ratio

• Financial structure: Reflects the company’s financial structure and its reliance on debt versus equity.
• Risk indicator: A higher ratio indicates more leverage, implying higher financial risk and potential difficulties in meeting debt obligations.
• Investment decisions: Investors use this ratio to evaluate the risk associated with the company’s capital structure.

3. Debt-to-capital ratio

The debt-to-capital ratio measures the proportion of debt used in the company’s total capital structure. It is calculated as:

Importance of debt to capital ratio

• Capital Structure Analysis: Provides insight into the company’s capital structure and the proportion of debt financing.
• Risk and Return: A higher ratio indicates more debt in the capital structure, which can increase potential returns and financial risk.
• Strategic Planning: Helps management assess the balance between debt and equity financing and make strategic financing decisions.

4. Debt-to-EBITDA ratio

The debt-to-EBITDA ratio compares a company’s total debt to its earnings before interest, taxes, depreciation, and amortization (EBITDA). The formula is:

Importance of debt to EBITDA ratio

• Debt Servicing Capability: It indicates the company’s ability to service its debt using operational earnings.
• Financial Health: A lower ratio suggests better financial health and a greater ability to handle debt obligations.
• Creditworthiness: Lenders use this ratio to evaluate a company’s creditworthiness and its capacity to meet debt payments.

5. Debt-to-income ratio (Commonly used for Personal Finance)

The debt-to-income ratio measures the percentage of an individual’s gross income that goes toward debt payments. The formula is:

Importance of debt to income ratio

• Credit Evaluation: Used by lenders to assess an individual’s ability to manage monthly debt payments and determine loan eligibility.
• Financial Stability: A lower ratio indicates better financial stability and a greater ability to manage existing debts.
• Personal Finance: Helps individuals understand their debt levels in relation to their income, guiding financial planning and debt management.

Real World Examples of Debt Ratio

Now that you know why the debt ratio is important and how to calculate debt ratio, let’s take real-world examples to make it even easier to understand.

Amazon 

By examining Amazon’s balance sheet, we can gain insights into how much of Amazon’s assets are financed through debt. With total assets of $527 million and details on short-term and long-term debt, we can apply the debt ratio formula to understand Amazon’s leverage and financial risk profile.

Here’s the data provided:

• Total Assets: $527,854 million
• Short-term Debt: $8,419 million
• Current Portion of Long-term Debt: $10,526 million
• Long-term Debt: $135,611 million

Calculating the debt ratio of Amazon

1. Identify Total Debt:
   • Total Debt = Short-term Debt + Current Portion of Long-term Debt + Long-term Debt
   • Total Debt = $8.419 billion + $10.526 billion + $135.611 billion
   • Total Debt = $154.55 billion
2. Identify Total Assets:
   • Total Assets = $527.85 billion (includes all current and noncurrent assets)
   • Calculate the Debt Ratio:
   • Debt Ratio = Total Debt / Total Assets
   • Debt Ratio = $154.55 billion / $527.85 billion
   • Debt Ratio ≈ 0.293 (or 29.3%)

Debt ratio analysis

Amazon’s debt ratio of approximately 29.3% indicates that around 29.3% of the company’s assets are financed through debt. This relatively moderate debt ratio suggests that Amazon uses a balanced approach to leverage, maintaining a mix of debt and equity to finance its assets. This level of debt can indicate a manageable financial risk, as a significant portion of the company’s assets is not dependent solely on debt financing.

It’s important to note that different industries have varying benchmarks for what constitutes a healthy debt ratio.

Debt Ratio Interpretation

Interpreting the debt ratio involves understanding its implications for the company’s financial health and risk profile. It involves comparing the debt ratio with industry benchmarks, considering the company’s specific circumstances. This helps stakeholders make informed decisions.

Now let’s understand how to interpret different debt ratios:

• High Debt Ratio: A high debt ratio (typically above 60%) or over 1 suggests that a company is heavily reliant on debt financing. This can indicate higher financial risk, especially if the company faces downturns or has volatile earnings, as it must meet its debt obligations regardless of revenue fluctuations.
• Low Debt Ratio: A low debt ratio (typically below 40% or below 0.4) indicates that a company uses less debt in its capital structure. This suggests lower financial risk and greater financial stability, though it might also mean the company is not fully leveraging debt to finance growth opportunities.

It’s important to note that the good debt ratio varies by industry. Businesses should aim for a debt ratio that balances leveraging debt for growth while maintaining the ability to service debt comfortably.

For instance, a tech company with a debt ratio of 25% indicates it has a relatively low reliance on debt, which is typical for the industry due to its high profitability and low capital expenditure needs. On the other hand, a manufacturing firm with a debt ratio of 55% might be considered standard given the industry’s heavy reliance on debt to finance large equipment and facility costs.

Leveraging Automation for Effective Debt Management 

Leveraging automation for effective debt management is crucial, where companies face the challenge of optimizing collections processes while maximizing productivity. With HighRadius’ collections management software equipped with AI capabilities, businesses can prioritize their efforts towards the most critical tasks. For instance, by utilizing AI prioritized worklists, companies can focus on the top 20% of delinquent customers, ensuring that resources are allocated where they are most needed.

How Highradius helped Staples Inc reduce bad debt by 20% ?

About Staples Inc.

Staples Inc., a leading CPG company, transformed its A/R landscape by digitizing its manual, paper-based collections with HighRadius Collections Software.

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Wrapping Up

The debt ratio is an essential metric for assessing a company’s financial stability and risk. Maintaining a good debt ratio is key to strategic financial planning, enabling companies to leverage debt for growth without compromising their ability to meet obligations. For business owners and investors alike, the debt ratio is not just a number—it’s a critical indicator of financial health and future viability.

FAQs

1) Can a debt ratio be negative?

When a company has a negative debt ratio, it signifies that its liabilities exceed its assets, resulting in negative shareholder equity. This means the company owes more than it owns, which is considered highly risky. Negative shareholder equity can lead to financial distress and bankruptcy. 

2) Is 75% a good debt ratio?

A debt ratio of 75% means that 75% of a company’s assets are financed by debt. Whether this is “good” varies based on industry benchmarks and the company’s specific circumstances. But generally a debt ratio of 0.4 or below is considered to be favorable and as it suggests a lower reliance on debt.

3) What is a bad debt ratio?

A bad debt ratio is generally considered to be one that indicates a level of debt that may jeopardize the financial stability of the company. Typically, a debt ratio is considered high or bad when it exceeds industry benchmarks. Generally, ratios above 0.6 are considered bad.