One of the most crucial parameters to assess the health of a particular company is its financial position. The debt ratio, also known as the risk gearing ratio, is used to carry out the financial leverage of a company and to calculate the weight of the debt ratio and total debt and financial liabilities to total capital (equity held by the shareholder).
Let's have a look at what's in store:
- Introduction
- What Is the Debt Ratio?
- The Technical Side of Debt Ratio
- Interpretation of Debt Ratio
- Analysis of Interpretation:
- What is Total Debt?
- How is the Debt Ratio Calculated?
- Examples of debt ratio for personal and business purposes:
- Importance and use of debt ratio formulas
- Benefits of Calculating the Debt Ratio
- Limitations of the Debt Ratio
- What Are the Risks Associated with Debt Ratio?
- What is the ideal Debt Ratio?
- Types of Debt Ratio
Introduction
In simple words, the debt ratio is calculated to measure the company’s capability to pay back its liabilities and obligations. If the debt ratio is higher, the company is receiving more money through risky loans, and if the potential debt is too high, it is at risk of bankruptcy during these periods. It is a substantial consideration for investors and lenders, as they prefer a low debt ratio as they feel that their interests are protected when the business is not performing well.
However, this debt ratio is beneficial in determining the amount of leverage the company is using, as it is a comparison of the company's total liabilities to its capital and determine. The risk of long-term debt is different from short-term debt, so investors are changing their gear to focus entirely on long-term debt.
What Is the Debt Ratio?
One must always spend according to what he has and borrow according to what he can repay. It is a basic life rule which should be thoroughly applied in businesses and organizations. The debt ratio is a simple financial indicator that represents a debt to capital.
The Technical Side of Debt Ratio
The formula for the debt ratio is dividing the total debt of the company by the total assets/stocks/equity held by the company/shareholders.
Debt ratio = Total Liabilities / Total Asset or Shareholder’s Equity
- ‘Total Liabilities’ considers all the debt that the company bears
- The Shareholder’s Equity (SE) is the net worth of a company
Net Assets= Assets – Liabilities
- SE is the owners` claim over the company`s value after deducting all the debts and liabilities that they owe
As a shareholder, you become a part-owner of the company and your ownership depends on the percentage of shares you own in proportion to the total number of shares that a company has issued.
More preference is given to the company`s creditors, lenders, and debenture holders than the equity shareholders at the time of disbursement.
Investing in stocks is a simple calculation wherein stockholders are paid off before the owners are paid back from the company`s assets. SE is the capital's ability to cover a company's liabilities. It can be negative or positive depending on the business activities of the company. This is an important indicator of a company's financial condition and makes the debt ratio an important representation of a company's financial condition.
Interpretation of Debt Ratio
This debt ratio is useful for analyzing a company's financing strategy. This indicator helps you know whether a company is using stocks or liabilities to do business.
- High debt ratio: A high debt ratio indicates a high risk. This means that the company is borrowing more money to raise business funds due to the lack of funds in the company. In other words, it means that it is involved in debt lending because its finances are in the red
- Low debt ratio: This means that the company is overcapitalized and does not need to borrow to fund the business or business. A company has more capital than debt, which speaks to the company
Interpretation: As we correctly stated, high-level leverage means that the company is in the red and borrows more than its own money, and low-level leverage means that the company uses more of its assets. And it shows that there is little borrowing.
Now, by definition, we can conclude that high leverage is bad for businesses and is negatively evaluated by analysts.
Analysis of Interpretation
Looking at the debt ratio again, the debt ratio is calculated by dividing the total debt by capital. Depending on the type of industry, a high-level DE may be common in some, while a low-level debt ratio may be common in others.
Capital-intensive industries such as manufacturing can have a high debt ratio, while services and technology-focused industries have relatively low capital and growth needs, which can lead to a low debt ratio. This shows that a company's debt ratio needs to be treated with caution compared to other industries.
What is Total Debt?
A company's total debt is the sum of current debt, long-term debt, and other fixed payment obligations that the company incurs during its normal operating cycle. Creating a debt plan helps you classify your debt according to specific parts. Not all short-term and long-term debt is considered debt. Let us understand what represent debt and what doesn’t:
Considered debt:
- Drawn line-of-credit
- Current portion of Long-Term Debt
- Capital lease obligations
- Notes payable with maturity within a year
- Notes payable with maturity more than a year
- Long-Term Debt
- Bonds payable
Not considered debt:
- Accounts payable
- Deferred revenues
- Accrued expenses
- Dividends payable
How is the Debt Ratio Calculated?
The debt ratio is formulated by dividing a company’s total liabilities by the total assets/shareholder’s equity. The formula is like this:
Debt ratio = Total Liabilities/Total Assets or Shareholder’s Equity
The total liabilities include short-term and long-term debts, along with fixed payments obligations.
Calculating a company's debt ratio is imperative to analyze if a company is exposed to financial risk. The general method of calculating debt ratio:
Determine the total debt
Your company's total debt is the sum of that debt and other financial obligations. It is a combination of short-term debt and long-term debt. Examples of total debt are wages, credit card debt, utilities, or invoices to be paid. Most often, it's the money your company is borrowing at any given time.
Determine your total assets in the business sense
"Total assets" refers to the total number of assets in a company. Assets retain their value, but can also be depreciated over time. Examples of total assets include commodities, inventories, and accounts receivable. They are units owned by your company.
Calculate the debt ratio
Once you have identified both your total liabilities and your total assets, you are ready to calculate your debt ratio. To calculate the debt ratio, divide the total liabilities by the total assets.
It is important to note that the low or high debt ratio depends on the particular industry.
However, a debt ratio greater than 1 indicates high future financial risk, and a low debt ratio (usually around 0.5) means that the business has a good financial base and can be protracted.
Examples of debt ratio for personal and business purposes
Example 1
Mr. Rajesh has a bakery with total assets of 50,000$ and liabilities of 20,000$, the debt ratio is 40%, or 0.40. This debt ratio is calculated by dividing 20,000$ (total liabilities) by 50,000$ (total assets). If the debt ratio is 0.4, the company is in good shape and may be able to repay the accumulated debt.
Example 2
Mr. Narayan has a furniture business and has taken a business loan of 100,000$ and retained earnings of 25,000$, its debt ratio will be 4. This is because 100,000$ (total debt) divided by 25,000$ (total capital) is 4 (debt ratio) which is a high-risk debt ratio and a dangerous investment.
Example 3
Let`s say Mr. Max is running a clothing store and pays its employees 50,000$ and has total assets amounting to 100,000$. To calculate the debt ratio, divide 50,000$ (liabilities) by 100,000$ (assets). This means the store has a debt ratio of 0.5 which is generally considered favorable.
Example 4
Let's say you recently ventured into a startup company and have borrowed funds from a bank as a personal loan. The bank has determined that your business has total assets of 50,000$ and total liabilities of 5,000$. Divide 5,000$ by 50,000$ to calculate the debt ratio. This results in a debt ratio of 0.1. This is a very cheap and low-risk debt ratio. In these situations, your bank should be fine in lending you a loan to initiate your business.
Example 5
You are planning to take a holiday with your family. Let's say you have 600,000$ in total assets and 150,000$ in liabilities. To calculate the debt ratio, divide the liability (150,000$ ) by the total assets (600,000$ ). This results in a debt ratio of 0.25 or 25 percent. Since this is less than 1, this is considered a low-risk debt ratio and you may go for that much longed-holiday or even seek financial assistance from a bank to pay for your vacation.
Importance and use of debt ratio formulas
This debt ratio formula is used for the following purposes.
1. Top Management:
The first group to use this debt ratio is the top management of the company, which is directly responsible for the development or reduction of the company. Based on this indicator, top management recognizes whether the company has sufficient resources to meet its obligations.
2. Investors:
The second group that is interested in finding out the debt ratio of a company is investors, who want to confirm the position of the company before investing money in it. For this reason, investors need to know if a company has sufficient assets to cover the costs of its liabilities and other obligations. This indicator also measures the financial leverage of a company. It also tells investors the leverage of the company. If a company has a higher level of liability compared to its assets, it has higher financial leverage and vice versa.
3. To Estimate the Financial Leverage:
The debt ratio is an important way to identify the financial stability and health of a business. If a company's debt ratio exceeds 0.50, the company is called a leveraged company. This shows that the company has more leverage in its capital structure. Companies with low debt ratios are said to be conservative. Companies with a debt ratio of less than 0.50 are stable and have the potential for longevity.
4. For Financing:
Companies can raise additional funding from outside for expansion. Benchmark debt ratios can vary from industry to industry, but a company's .50 debt ratio can be a reasonable one to obtain extra financing for the smooth running of the company.
If a company's debt ratio is 1, it means that the company's total debt is equal to its total assets. Or you could say that if a company wants to repay its debt, it has to sell all its assets. If a company has to pay its debt, it has to sell all its assets, in which case the company can no longer operate.
Benefits of Calculating the Debt Ratio
- A low debt ratio means that a company can meet its debt through cash flow and use it to increase return on equity and strategic growth
- Since the cost of debt is lower than the cost of capital, raising the leverage to some extent can lower the weighted average cost of capital (WACC) of the company
- The more debt you use, the better your company's return on equity (ROE). However, if you use liabilities instead of equity, the amount of equity will be lower and the return on equity will be higher
Limitations of the Debt Ratio
- The debt ratio of 1 is considered to be the same which means Total liabilities = capital. This allocation is industry-specific and depends on your current and fixed asset share. Capital-intensive companies are said to have a higher debt ratio than service companies
- The maximum permissible debt ratio for more companies is 1.5 - 2 or less. Large companies with a debt ratio score greater than 2 are acceptable
- The debt ratio indicates that a company may not be able to generate enough cash to meet its debt. However, a low-leverage company means that the company is taking advantage of the high profits that financial leverage can bring
What Are the Risks Associated with Debt Ratio?
High levels of debt carry two major risks.
- If the company has a high debt ratio, the losses incurred will be worse and the company will have difficulty paying off the debt
- If the level of debt is too high, the cost of debt and the cost of capital will suddenly rise. In addition, WACC's weighted average cost of capital will become too high and stock prices will fall
What is the ideal Debt Ratio?
The simple answer to this is that the debt ratio quota should ideally not exceed 2. A debt ratio of 2 means that the company has 1 unit of capital for every 2 units of debt. This is very high and indicates a high risk. Ideally, there is no such thing as an ideal debt ratio.
Yes, the debt ratio greater than 2 is very high, but in some industries such as manufacturing and mining, the normal debt ratio can be 2 or more.
In other industries, debt ratio 2 may not be normal. What we need to see is the industry average. From this, we can infer you should be vigilant while comparing debt ratios and that the same should be done for companies in the same industry and industry benchmarks.
Types of Debt Ratio
- Debt-to-assets ratio: To calculate the debt ratio, divide the total liabilities by the total assets. The greater the debt ratio of a company, the greater its financial leverage
- Debt-to-equity ratio: To calculate this ratio, you must divide the company's total liabilities by the shareholder’s equity
- debt-to-capital ratio: To calculate the leverage of a company, divide the total liabilities by the sum of its debt and total equity
- Debt-to-EBITDA ratio: This debt ratio is calculated by dividing the company's total liabilities by its sum of earnings before depreciation, taxes, interest, and amortization
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Conclusion
The concept of debt ratio is essential. You can use the equity and debt aspects to depict the financial position of a company. The debt ratio checks whether a company is dependent on liabilities or equity for running its business. This debt ratio is crucial for all stakeholders and holds relevance in finding out the current debt/asset situation of an organization.
Key Takeaways
- The debt ratio is a simple calculation of a company’s total debt to total assets
- Capital-intensive companies typically have a much higher debt ratio than other companies, as this ratio varies widely from industry to industry
- A company's debt ratio can be calculated by dividing total liabilities by total assets. A debt ratio of more than 1.0 or 100% means that the company has more liabilities than assets, and a debt ratio of less than 1.0 or 100% means that the company has more assets than liabilities
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