The debt ratio formula and calculation are used to compare the total debt of a company to its total assets. This ratio is used to determine the extent of a company’s leverage.
Companies, in order to indicate their financial status clearly, generate the required financial statements to present to their Investors and stakeholders. These financial statements include the cash flow statement, balance sheet, income statement, and statement of shareholder’s equity.
As investors go through the company’s financial statements, they analyze the position of the company in question by computing the total debts with respect to the total assets and arrive at a ratio known as the debt ratio or debt to asset ratio. This ratio determines the portion of a business’s assets that are financed through debt.
This article will discuss the debt ratio formula, and how it is calculated. But first, let’s have a look at what the debt ratio is and its use.
What is debt ratio?
The debt ratio is a financial metric used to determine the percentage of a company’s assets that are financed through debt, thus, evaluating the extent of a company’s financial leverage. It is simply the ratio of a company’s total liabilities (total debt) to its total assets (the sum of fixed assets, current assets, and other assets such as goodwill).
The debt ratio is used in assessing the financial stability of a firm, given the number of asset-backed debts it possesses. Debt ratios are known to vary widely across industries. For instance, capital-intensive businesses, like pipelines and utilities tend to have much higher debt ratios than other businesses such as companies in the technology sector.
Since the debt to assets ratio is used to compare the total debt of a company with respect to its total assets, it becomes one of the solvency ratios for investors. This ratio is represented as a decimal value or in the form of a percentage helping investors understand how likely companies or businesses are to go bankrupt in the event of consecutive defaults.
For instance, a business that has total assets that amount to $2 million and $500,000 in total liabilities would have a debt ratio of 0.25 or 25%. The total liabilities of the company divided by its total assets shows the investors the proportion of the business assets that are financed through debt. To an investor, the debt ratio of 0.25 means 25% of this business is financed through debts.
If the debt to asset ratio of a company is less than 0.5, it is assumed that most of the company’s assets are financed through equity. But if the debt ratio is more than 0.5, it is assumed that most of the company’s assets are financed through debt. Therefore, companies with high debt ratios are said to be highly leveraged. So, the higher the debt to asset ratio, the greater the risk that will be associated with the operations of the company.
Additionally, a high debt to assets ratio may indicate that the company has low borrowing capacity, which in turn will lower the financial flexibility of the company. Furthermore, the debt ratio of a company, like all financial ratios should be compared with its industry average or other competing companies.
The debt ratio interpretation is used by investors and analysts to determine how much risk a company has acquired. Whether a company’s debt ratio is high or low may depend on the nature of the business and its industry. Nevertheless, a total debt ratio analysis with a value greater than 1.0 (100%) indicates that the company has more debt than assets. Whereas, a total debt ratio analysis with a value less than 1.0 (100%) indicates that the company has more assets than debts. The debt ratio interpretation can be used in conjunction with other measures of financial health to help investors determine the risk level of a company.
High debt ratio explanation
A business with a high debt ratio is associated with a high-risk level meaning that the business has taken on a large amount of risk. A business with a debt ratio above 0.5 or 50% is said to have a high debt ratio and is seen to be highly leveraged. This tells investors that most of the business’s assets are financed through debt and not equity.
More so, in some scenarios, a high debt ratio may be interpreted as a business that is in danger if creditors were to suddenly insist on the repayment of their loans. Hence, the reason why investors prefer a lower debt ratio. Therefore, the higher the debt ratio of a company, the more leveraged it is, indicating greater financial risk.
Nevertheless, leverage is an important tool used by companies to grow, and many businesses find sustainable uses for debt. Therefore, companies should compare themselves to their direct competitors or industry average in order to find a comfortable debt ratio.
Low debt ratio interpretation
A business with a low debt ratio is associated with a low level of risk meaning that the business is more independent and does not need to rely heavily on borrowed funds. Therefore, the business is more financially stable and preferable. A business with a debt ratio below 0.5 or 50% is said to have a low debt ratio. This tells investors that most of the business’s assets are fully owned and financed through the business’s own equity and not debt.
Negative debt ratio analysis
Can a company’s debt ratio be negative? Yes, it’s possible. A company with a negative debt ratio simply indicates that the company has negative shareholder equity. This means that the liabilities of the company outnumber its assets. In most cases, a negative debt ratio is considered a very risky sign, showing that the company may be at risk of bankruptcy.
What is a good debt ratio?
What may be considered a good debt ratio will depend on the nature of the business and its industry. However, generally speaking, a debt ratio that is below 1.0 would be seen as relatively safe, while debt ratios of 2.0 or higher would be considered risky.
Furthermore, it is important to note that some industries, such as banking, are known for having much higher debt ratios than others. Take, for instance, carrying out a debt ratio analysis on a company with a total debt of $30 million and total assets of $100 million will give a debt-to-asset ratio of 0.3 or 30%. Now, the question of whether this company is in a better financial situation than a company with a debt to asset ratio of 0.4 or 40% will depend on the industry.
For an industry with volatile cash flows, a debt ratio of 30% may be considered too high because most businesses in such an industry take on little debt. Therefore, a company with a high debt ratio compared to its peers would find it expensive to borrow, and should circumstances change, the company may find itself in a crunch. A debt ratio of 40%, on the other hand, may be easily manageable for a company in business sectors like utilities where cash flows are stable and higher debt ratios are usual.
Debt ratio formula
The total debt ratio formula is used to compare the total debt of a company with respect to its total assets which is represented as a decimal value or in the form of a percentage.
The debt ratio formula is expressed as:
Debt ratio= Total debt / Total Assets
Debt ratio= Total Liabilities / Total Assets
Total debt= The short-term and long-term liabilities of the company
Since the debt to asset ratio shows the overall debt burden of the company, the debt ratio equation uses the total liabilities and the total assets, and not just the current debt. The ratio is shown in decimal format because it calculates total liabilities as a percentage of total assets.
Debt ratio calculation
The debt ratio calculation is done by simply dividing the total debt (liabilities) by the total assets. The total debts of the company include all its short and long-term liabilities such as lines of credit, bank loans, etc. While the total assets of the company include all fixed, current, and intangible assets; such as equipment, property, goodwill, etc.
Here are a few examples of how to calculate debt ratio in accounting. We will be using debt ratio examples from different industries to contextualize the ratio:
How to calculate debt ratio example 1
Company ABC in the retail coffee and snacks store industry listed $3.93 billion in long-term debt on its balance sheet for the fiscal year ended Oct. 1, 2017, and $0 in the short-term and current portion of long-term debt. Calculate the debt ratio if the company had total assets of $14.37 billion.
How to calculate debt ratio of Company ABC using the total debt ratio formula:
Debt ratio= Total debt / Total Assets
Debt ratio= $3.93 billion / $14.37 billion
Debt ratio= 0.2734 or 27.34%
Debt ratio interpretation: This means Company ABC has a debt ratio of 0.27. Now, to assess if this ratio is high, we should consider the capital expenditure that goes into opening a business in the retail coffee and snacks store industry. Also, we should consider the expenses that go into purchasing expensive equipment, much of which is not used frequently, leasing commercial space, and renovating it to fit a certain layout. The business must also employ and train employees in an industry with exceptionally high employee turnover, including adhering to food safety regulations for all its thousands of locations in different countries.
Putting all these into consideration, a debt ratio of 27% isn’t so bad especially as the industry average for the industry that the company belongs to was about 65% in 2017. The debt ratio analysis shows that Company ABC has an easy time borrowing money because creditors trust that the business is in a solid financial position and can be expected to pay them back in full.
How to calculate debt ratio example 2
Berkshire Hathaway is an American multinational conglomerate holding company that owns businesses in rail transportation, insurance, energy generation and distribution, manufacturing, and retailing. Using the exert from Berkshire Hathaway’s balance sheet for the fiscal year of 2020 below, let’s calculate the debt ratio for Berkshire Hathaway.
For the fiscal year (FY) ended December 31, 2020, it can be seen from the exert of Berkshire Hathaway 2020 balance sheet above, that the company had total liabilities of $422,393,000 and total assets of $873,729,000,000.
How to calculate the total debt ratio of Berkshire Hathaway using the total debt ratio formula:
Debt ratio= Total Liabilities / Total Assets
Debt ratio= $422,393 million / $873,729 million
Debt ratio= 0.4834 or 48.34%
Debt ratio explanation: This means Berkshire Hathaway had a debt ratio of 0.4834 (48.34%). The debt ratio of Berkshire Hathaway is low as the ratio is below 0.5 or 50%. This could indicate a low level of risk meaning that the business is more independent and does not need to rely heavily on borrowed funds. This tells investors that 48.34% of the business is financed through debts meaning that a larger portion of the business’s assets is fully owned and financed through the business’s own equity and not debt.
Calculating debt ratio example 3
Apple is an American multinational company in the Information technology sector/industry that specializes in consumer electronics, software and online services. Using the exert from Apple’s balance sheet for the fiscal year of 2020 below, let’s do a debt ratio calculation for Apple.
For the fiscal year (FY) ended September 26, 2020, it can be seen from the exert of Apple, Inc. (AAPL) 2020 balance sheet above, that the company had total liabilities of $258,549,000,000 and total assets of $323,888,000,000.
How to calculate the debt to asset ratio of Apple using the total debt ratio equation:
Debt ratio= Total Liabilities / Total Assets
Debt ratio= $258,549 million / $323,888 million
Debt ratio= 0.7982 or 79.82%
Debt ratio analysis: This means Apple had a debt ratio of 0.7982 (79.82%). The debt ratio of Apple seems to be high because it is a capital-intensive company. Financial firms, banks, and capital-intensive businesses, like pipelines, large manufacturing companies, and utilities tend to have much higher debt ratios than other businesses because they utilize a high level of debt financing as a common practice.
Example 4: Comparing the debt to asset ratio among companies
Let’s examine the debt ratio for three companies, Alphabet, Inc. (Google), Costco Wholesale and Hertz Global Holdings. The table below summarizes the total debts and assets from the balance statements of Alphabet, Inc. (Google), Costco Wholesale and Hertz Global Holdings for their fiscal quarter ending March 31, 2022, May 8, 2022, and March 31, 2022, respectively. The balance sheet data below will be used to calculate the debt ratio and compare the 3 companies.
|Balance sheet item||Alphabet, Inc. (Google)||Costco Wholesale||Hertz Global Holdings|
|Total debts||$107,633 million||$31,845 million||$18,239 million|
|Total assets||$359,268 million||$63,852 million||$20,941 million|
How to calculate the debt ratio of the 3 companies using the debt ratio formula:
Debt ratio= Total debt / Total Assets
Calculating the total debt ratio of Alphabet, Inc. (Google)
Debt ratio= $107,633 million / $359,268 million
Debt ratio= 0.2995 (0.3) or 29.95%
Calculating the total debt ratio of Costco Wholesale
Debt ratio= $31,845 million / $63,852 million
Debt ratio= 0.4987 (0.5) or 49.87%
Calculating the total debt ratio of Hertz Global Holdings
Debt ratio= $18,239 million / $20,941 million
Debt ratio= 0.8709 (0.9) or 87.09%
Debt ratio analysis: From the debt ratio calculation done it is seen that Google has a ratio of 0.3, Costco has a ratio of 0.5 and Hertz has a ratio of 0.9. It can be observed that Google is likely to secure additional capital at potentially lower rates compared to Costco and Hertz being that it is not weighed down by debt obligations.
Despite the fact that the debt balance of Google ($107,633 million) is more than three times higher than Costco’s ($31,845 million), the company still carries proportionally less debt relative to its total assets, compared to Costo and Hertz.
Costco had a debt ratio of 0.5 shows that the company has been financed nearly evenly by debt and equity. This implies that the company has roughly the same amount of debt as it does in common stock, retained earnings, and net income.
Hertz, on the other hand, had a higher debt ratio compared to Google and Costco. This company is relatively known for carrying a high degree of debt on its balance sheet. Despite the fact that its debt balance is smaller than Google and Costco’s, its debt ratio shows that almost 90% of all the assets that the company owns are financed by debt.
In conclusion, among the 3 companies compared, Hertz has the lowest degree of flexibility as it has legal obligations to fulfill. Google, on the other hand, has flexibility regarding dividend distributions to shareholders.
More so, it is very crucial to understand the industry, size, and goals of each company to interpret their debt to asset ratio.
For instance, Google is an established company and is no longer a technology start-up, so the company has proven revenue models that are easier to attract investors. Unlike Hertz which is a much smaller company that may not be as attractive as Google to shareholders. Therefore, Hertz may find the demands of investors too much to secure financing and would rather turn to financial institutions for its capital.
Importance of debt ratio formula
The debt ratio is used in assessing the financial stability of a firm, given the number of asset-backed debts it possesses. This ratio is important when comparing the total debt of a company with respect to its total assets.
Two sets of people find this ratio very useful and important. The first set is the top management of the company which is directly responsible for the expansion or contraction of a company. The top management can use the debt to asset ratio to assess whether the company has enough resources to pay off its debts and financial obligations.
The second set of people that find the debt ratio very useful is investors. Investors use the debt-to-asset ratio to assess the position of a company before they make their investment decision. Before these investors finally decide to put their money into a company, they must know whether the company has enough assets to bear the expenses of debts and other financial obligations.
Therefore, the debt ratio is very significant in measuring the financial leverage of the company. The ratio tells the investors how leveraged the firm is because a company that has a higher level of liabilities compared to its assets, has more financial leverage and vice versa.
In as much as the debt ratio is very useful, there are some limitations to the ratio. When using the debt ratio to compare industry averages, the financial manager or business owner has to ensure that the other companies in the industry with which they are comparing the ratio are using the same items as them in the equation.
For instance, all of the companies in the industry must use long-term debt or total debt in the numerator of the equation. The data will be corrupted and there will be no useful data if some companies use total debt and others use only long-term debt.
Another issue with the debt ratio is the fact that in an industry, different businesses use different accounting practices. Therefore, any comparison will be invalid if some of the companies use one depreciation method or one inventory accounting method and other companies use other methods.
This means that when using the debt ratio, in order to get an accurate debt ratio analysis, financial managers and business managers have to make use of good judgment and look beyond the numbers.
Other forms of the ratio
- Long-term debt-to-assets
- Capitalization ratio
- Equity ratio
- Debt-to-capitalization ratio
- Debt-to-capital ratio
- Debt-to-EBITDAX ratio
- Debt-to-EBITDA leverage ratio
All debt ratios analyze and assess a company’s relative debt position. Listed above are other common forms of debt ratios varying from debt-to-equity, Long-term debt-to-assets, to other leverage and gearing ratios.