Debt Ratio

What is Debt Ratio ?

Debt ratio is a leverage ratio used to quantify the percentage of Debt that is funded by assets of the company. It also known as Debt-to-Assets ratio.

It is a measure of financial leverage employed by a company. It is used by creditors to identify if the company is solvent enough to meet is debt obligations. It helps analysts and investors to understand, if the company will be able to provide the promised Return on Investments after it has met the costs associated with employing debt capital.


How is Debt ratio calculated ?

The Debt ratio is calculated using the formula

Debt Ratio = Total Debt / Total Assets

Where 

Total Debt = Current Liabilities + Long Term liabilities    ;   

Total Assets = Current assets + Fixed assets


How do you Interpret Debt Ratio ?

A Debt Ratio greater than 1, implies that a major portion of the liabilities of a company has been financed by assets. At this point the liabilities are more than the value of assets held. The company has placed a greater reliance on Debt as a source of funds and will have to bear the related costs.

A Debt Ratio less than 1, implies that a major portion of the Debt of a company has been financed by Equity. In other words, the Assets exceed the Debt liability of the company.

When the Debt ratio is equal to 1, the amount of assets is equal to the amount of debt owed.      

 What is a good Debt Ratio ?

The concept of a good Debt ratio differs over range of industries.

A company in the manufacturing industry will typically have a debt ratio of 0.60 and above. This is a good debt ratio given the capital intensive nature of the industry. This also implies that the
company is taking a higher level of risk. Thus a debt ratio of 0.60 and above is a good debt ratio for manufacturing industry.

A services based or technology based start up will have a debt ratio lower than 0.40. The reliability on borrowed capital is less in these companies, thereby reducing the financial risk involved.

The above scenarios when interchanged, result in a different interpretation.

For example  : A start up having a debt ratio higher than 0.6 implies that it is heavily reliant on debt capital as its major source of fund. It is taking a high risk and the assets of the company will not be sufficient to repay its debt obligations when the time arises.

Thus a Good Debt ratio is a function of the nature of industry and the credit worthiness of a company.                                                                                                                                  

 Debt ratio calculation with example

ABC Co. has provide the following information with respect to the balance sheet of 2020.

Current liabilities = $ 500,000   ; Long term Debt = $ 1,500,000   ; 

Current assets = $ 1,000,000   ; Fixed assets   = 3,000,000    ;

Based on the information provided, calculate the Debt ratio.

Solution :

The Debt ratio is calculated using the formula

Debt Ratio = Total Debt / Total Assets

As per the information provided in the question,

Current Assets = $ 1,000,000   ;  Fixed Assets = $ 3,000,000   ;

Long – term Debt = $ 1,500,000     ;    Current liabilities  = $ 500,000    ;

Thus we have

Total Assets = Current Assets + Fixed Assets = $ 1,000,000  + $ 3,000,000  = $ 4,000,000  ;

Total Debt = Long – term Debt + Current liabilities = $ 1,500,000 + $ 500,000 = $ 2,000,000   ;

Applying the above information in the formula for debt ratio we have

= $ 2,000,000  / $ 4,000,000

= 0.50  ( when expressed in decimal form )

= 50  % ( when expressed in percentage form )

Thus the Debt ratio = 0.50

The above debt ratio of 0.50 implies that 50 % of the debt is financed by assets of the company.

 

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