Debt Ratio is the Financial Ratio that use to assess and measure the financial leverage of the entity over the relationship between total debt (long term and short term debt) and total assets.
Basically, if the ratio is higher than one, that means the total liabilities are higher than total assets which means the entity’s financial leverage is high and face more financial risks.
If the ratio is less than one, that means the total liabilities are lower than assets which subsequently imply that the entity’s financially healthy.
Debt Ratio provides the investors with an idea about an entity’s financial leverages; however, to study detail, the analysis should break down into long term and short term debt. A low debt ratio does not always good and a high debt ratio does not always bad.
This ratio is sometimes called debt to assets ratio. You will get a better understanding of this in the formula, for example, and deep analysis below.
Debt Ratio Formula:
In general, the formula of debt ratio is as follow:
- Total Liabilities are the total debt that the entity owns to others at the specific reporting date. The total liabilities could be found in the balance sheet or you can substrate the total equity from total assets to figure out total liabilities. The accounting equation could also use as the reference to calculated liabilities and assets from the balance sheet. Liabilities here included both current liabilities and non-current liabilities. That mean debt here included not only long term loan from banks, but also including account payable as well as prepayment from customers.
- Total assets basically mean the control of the resources by the entity and will have future economic flow. In the balance sheet, total assets as the accumulation of both current and non-current assets. So, total assets including not only land, building, machinery, but also cash in banks, as well as cash on hand.
- This ratio measures in percentages or time. In general, investors and bankers prefer the debt ratio smaller than one. The smaller the ratio, the good sign the entity could pay the bank the loan.
ABC company has the following financial information as of 31 December 2015 as follow:
- Current asset = 300,000 USD
- Non current assets = 400,000 USD
- Current liabilities = 200.000 USD
- Current liabilities = 300,000 USD
ABC is currently seeking a bank loan and the bank now assessing its financial leverages. Calculate the debt ratio of ABC?
Based on information about, we got total assets = 700,000 USD and total liabilities = 500,000 USD.
Debt ratio = total liabilities / total assets
Debt ratio = 500,000 / 700,000 = 0.85 time
Based on the calculation, the debt ratio of ABC as of 31 December 2015 is 0.85 time or we can say that ABC has total debt equal to 85% of its total assets.
Some analysts might try to break this ratio into a more specific component to ensure that the analysis result brings them a good reason.
For example, long term debt to total assets, short term debt to total assets, total debt to current assets and total debt to non-current assets.
These types of ratios will help the analyst to predict more possible scenarios and options whether the entity really has a good or poor financial position.
Debt ratio presenting in time or percentages between total debt and total liabilities.
This ratio help shareholders, investors, and management to assess the financial leverages of the entity. The entity is said to be financially healthy if the ratio is 50% of 0.5.
Between 50% to 100%, the financial position of an entity is in the grey alert which means that the right of liquidation might be happening. Over 100% means that the liabilities are higher than assets that the entity is facing bankruptcy.
The debt ratio is also very important for the banker to assess the financial situation for the purpose of secure their loan principle from being unable to pay.
When performing debt ratio analysis, there are certain matters that you need to consider. First is the result of your calculation whether it is positive or negative.
Positive and negative give us the clue that the entity being assess has a different financial position.
Second, the relative of assets and liabilities of the entity. Just because of the ratio good, it does not mean the entity has a good financial position.
Current cash flow and future cash flow also play very important points. The last one and probably the most important one is past records.
Remember, accounting records that are used to calculate the debt ratio is past transactions and they are able to be manipulated.
Advantages of Debt Ratio:
- Provide useful information about the entity Financial leverages. This ratio could help investors and shareholders to understand deeply about an entity’s financial situation. This is what most inventors and shareholders want to know in order to help to make better decisions making whether or they should invest more in the entity or else.
- Easy to understand by investors and shareholders. This ratio is very easy to understand. It’s a result shown in percentage or ratio that could help most of the inventors and shareholders who do not have a financial background to understand.
- Easy to calculate. This ratio is very easy to calculate and the formula itself is very straight forward. This is could help most financial statements analysts to calculate and analyze the ratio easily.
- Can compare to other entity with different size. As the ratio result as the percentages or ratio, it enables the investors and shareholders to compare the result of entity to others with different sizes as well as capital.
Disadvantages of Debt Ratio:
- Lack of future assessment, think more about past performance. This ratio provides the investors and shareholders with the past financial performance which might not help them to make the right decision for the future. As experienced, the entity might face financial difficulty manly because of current and future business situations.
- Chance of manipulation through accounting policies and treatment. This ratio uses the financial data that might be manipulated to make the related financial measurement become better which that financial data should not be like that if they were correctly records, measure and recognize.
- Depending on the only financial perspective. This ratio assesses the entity’s financial leverages depending on only financial data. For better decision making, incorporate non-financial data might help them to increase the accuracy of decision making.