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.
Purposes of Debt Ratio:
The debt ratio is a financial metric that measures the extent to which a company has financed its operations with debt compared to equity.
The debt ratio is a critical indicator of a company’s financial health and stability. It is an essential tool for investors and analysts to evaluate a company’s solvency, liquidity, and risk profile.
The primary purposes of the debt ratio are to assess a company’s leverage, evaluate its ability to meet its debt obligations, and determine its capacity to raise additional capital.
By analyzing a company’s debt ratio, investors and analysts can gain insight into its financial structure and assess the risk associated with investing.
A high debt ratio indicates that a company has a significant amount of debt relative to its assets, which may increase the risk of insolvency during an economic downturn or other adverse events.
On the other hand, a low debt ratio suggests that a company is less reliant on debt financing, which may reduce the risk of default and increase its financial stability.
In addition to assessing a company’s risk profile, the debt ratio can also be used to compare companies within the same industry or sector. Investors and analysts can use the debt ratio to identify companies with similar financial structures and compare their debt levels, profitability, and other financial metrics.
Overall, the debt ratio is a valuable financial tool that provides valuable insights into a company’s financial health, stability, and risk profile. By using the debt ratio to evaluate companies, investors and analysts can make more informed investment decisions and minimize the risk of financial loss.
Top 10 Advantages of Using the Debt Ratio as a Financial Metric:
- Measures leverage: A debt ratio is a useful tool for measuring a company’s leverage or its level of debt financing relative to equity financing.
- Financial stability insights: The debt ratio provides insights into a company’s financial stability by measuring the proportion of debt to assets.
- Evaluates ability to meet debt obligations: The debt ratio provides insights into a company’s ability to meet its obligations by measuring the proportion of debt to assets.
- Measures financial risk: The debt ratio can be used to measure a company’s financial risk by evaluating the proportion of debt to assets.
- Enables comparison across companies: The debt ratio can be used to compare the financial leverage of different companies in the same industry or sector.
- Evaluates risk profile: A debt ratio is a valuable tool for evaluating a company’s risk profile by assessing its debt level relative to its assets.
- Provides insights into solvency: The debt ratio can provide insights into a company’s solvency by measuring the proportion of debt to assets.
- Helps in decision-making: Investors and analysts can use the debt ratio to make informed decisions about investing in a company or industry.
- Helps in credit evaluation: A debt ratio is an essential tool for credit evaluators to assess a company’s creditworthiness.
- Measures profitability: The debt ratio can also be used to evaluate a company’s profitability by measuring the proportion of debt-financed assets.
The debt ratio is a versatile financial metric providing valuable insights into a company’s financial health, stability, risk profile, and profitability.
By using the debt ratio to evaluate companies, investors and analysts can make more informed investment decisions, minimize the risk of financial loss, and identify opportunities for growth and profitability.
Top 10 Disadvantages of Using the Debt Ratio as a Financial Metric:
- Ignores differences in interest rates: The debt ratio does not consider differences in interest rates, which can significantly impact a company’s financial health.
- Ignores differences in maturity dates: The debt ratio does not consider differences in the maturity dates of debt, which can affect a company’s ability to meet its debt obligations.
- Limited comparability: The debt ratio may not be directly comparable across different industries or sectors, as companies may have different financial structures and capital requirements.
- Limited information on cash flows: The debt ratio needs to provide information on a company’s cash flows, which can affect its ability to meet its debt obligations.
- Limited information on assets: The debt ratio needs to provide information on the quality or value of a company’s assets, which can impact its ability to obtain financing.
- Limited information on profitability: The debt ratio does not provide information on a company’s profitability, which is critical for evaluating its long-term financial health.
- Misleading in periods of rapid growth or decline: The debt ratio can be misleading during periods of rapid growth or decline, as it may not accurately reflect a company’s current financial position.
- Affected by accounting practices: The debt ratio can be affected by a company’s accounting practices, which can impact the accuracy and comparability of the metric.
- Limited predictive power: The debt ratio has limited predictive power for future performance, providing only a snapshot of a company’s current financial position.
- Ignores off-balance-sheet financing: The debt ratio does not consider off-balance-sheet financing, which can significantly impact a company’s financial health and risk profile.
Overall, while the debt ratio is a widely used financial metric, it has several disadvantages and limitations that investors and analysts should consider for financial analysis and decision-making.
By being aware of these limitations, investors and analysts can use the debt ratio more effectively and in conjunction with other financial metrics better to understand a company’s financial health and risk profile.