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What is a Debt Ratio?

2017-09-22T07:43:02+00:00

The term 'Debt Ratio' is included in the Accounting edition of the Financial Dictionary. Get yours now on amazon in ebook or paperback format. Read more here...

Debt Ratio refers to a highly favored financial ratio. This one measures the consumer or company’s debt leverage. This ratio is best explained as the ratio for all of the longer-term and shorter-term debt divided by all assets of the individual or enterprise. It is then expressed out in percentage or decimal format. Another way of stating it is the proportion of a firm’s assets financed by outright debt. The debt ratio is sometimes called the debt to assets ratio as well.

All else being equal, as this debt ratio is higher it means that the firm has a higher degree of leverage. This generally implies a higher amount of financial risk. Yet simultaneously it is true that such leverage is a critical tool which many corporations employ to expand. Countless firms have discovered many sustainable uses of such debt.

Naturally, acceptable and average debt ratios will range drastically from one industry to the next. Utilities and pipelines are capital-intensive firms. They will necessarily possess far greater debt ratios than do companies in such industries as technology. Consider a clear example to help understand this term better. When corporations have assets of $200 million and aggregate debts of $50 million, then the debt ratio would amount to 25 percent or .25 alternatively. This company would therefore be in a stronger financial position than a comparable one with a 35 percent debt to asset ratio, but not always.

This is because 25 percent debt to asset ratios can be excessive in an industry that boasts unstable cash flows. These businesses simply cannot assume too much debt. Such a firm that possessed an overly high debt ratio as measured up against its rivals would discover how costly additional borrowing would become. This means that it might fall into a cash crunch in shifting circumstances. The fracking industry starting in summer 2014 found itself in dire straits thanks to its huge debt levels and plunging energy prices.

At the same time, debt levels that amount to 35 percent could be easy to manage for those firms which are in an industry like utilities. The cash flows in these businesses are far stronger and more stable. Higher debt to assets ratios are not only acceptable in this business, they are expected. For those firms that find themselves with an over 100 percent debt ratio, you know that its debt levels actually exceed its amount of assets. Conversely, when firms possess a ratio under 100 percent, the firm possesses more assets than debt. Alongside other metrics for determining financial soundness, this ratio will allow investors to ascertain how high the risk level is for a given business.

Debt ratios do not take into account all money that a firm owes necessarily. While they will always count longer- and shorter-term debts, they will leave out liabilities. Some of these liabilities that do not figure into the calculations are negative goodwill, accounts payable, and “other” items.

Consider a real-world example of how this works out in practice. Starbucks possesses a debt ratio of around 22.5 percent. Morningstar considers that the typical ratio for the industry is more like 40 percent on average. This means that the Starbucks Corporation can easily borrow money on the markets. Creditors understand that its finances are solid as a rock. They anticipate receiving full repayment on time. The non-callable and fixed rate Starbucks’ bonds that mature in 2045 possess coupon rates of only 4.3 percent.

Contrast this with a basic materials firm like Arch Coal Incorporated. The industry of coal mining is regarded as highly capital intensive. This is why the industry forgives utilizing leverage to operate effectively. The average debt to assets ratio proves to be 47 percent. Yet Arch Coal Inc. has a 64 percent ratio. This makes it costly for them to borrow money. In fact their non-callable, fixed rate bonds that mature in 2023 come with a painful interest coupon rate amounting to 12 percent.

The term 'Debt Ratio' is included in the Accounting edition of the Financial Dictionary. You can get your copy on amazon in Kindle or Paperback version. See more details here.