Debt Ratio indicates the amount of leverage a company has taken on to finance its operations.
Essentially, any business is financed via two different vehicles, equity or debt. The debt ratio measure the amount of debt the company uses to operate its business. The higher this ratio, more debt the company hs on its books.
How to Calculate Debt Ratio
Debt ratio formula is a simple ratio of the total debt to the total assets.
Debt Ratio = Total Debt / Total Assets
Total debt includes both the long term debt and the current debt (including the current portion of the long term debt). This is not the same as total liabilities, which in addition includes accounts such as accounts payable, reserve accounts, etc. These accounts are not part of the Debt Ratio calculation.
Debt ratio is also called Debt to Assets Ratio.
As a measure of leverage, the debt ratio is a very useful indicator of the financial risk inherent in the company business. This of course depends on the industry and business dynamics. For example, in industries and businesses with stable cash flows and revenues, a high debt ratio is often not only acceptable, but also desirable. Debt is leverage and it increases profitability disproporationately as long as the cost of the debt is managed properly. Utilities are an example of an industry with predictable cash flows where high debt ratios are acceptable and desirable.
In other industries where revenues can be volatile, or for the companies that are just starting out, it is prudent to manage debt levels low as cost of debt can be high due to unpredictable cash flows.
Also bear in mind that often debt is issued against tangible collateral (secured debt). In manufacturing and industrial companies, there are siginificant tangible assets in form of mines, machinery, property and equipment, inventory, etc, that can be used to secure a debt. These industries also tend to be very capital intensive. Therefore, it is common to find businesses in these industries that are highly leveraged with high debt ratios.
Service businesses such as techonology companies normally have lower debt ratios as majority of the assets tend to be intellectual capital and R&D, commonly thought of as intangible assets.
Is Low Debt Ratio Always Better?
While a high debt ratio shows increased financial risk in the business, we need to keep in mind that debt is a cheaper form of financing. Equity financing is much more expensive as equity investors demand higher returns to compensate for a lack of security.
Therefore if a company is able to issue debt on good terms, it is often more desirable to see some debt on the books than all equity.
From an equity investor’s persepective, the debt investors get a fixed return, irrespective of how well the company does in the future. This means that if the company does exceedingly well, most of the incremental benefits accrue to the equity investors. In this sense, equity investors are better off if the company finances a good chunk of its operations using debt. In most of the industries, some level of debt on the books is highly desirable, and often the management does a disservice to the shareholders if they choose to remain debt free.
A high debt ratio is of course risky.
Normally in most industries, a debt ratio between 10% – 50% is comfortable and acceptable. Individual situations may be different though, but this is a good benchmark to work with.