The debt ratio is a financial metric that measures the extent of a company’s leverage by comparing total debt to total assets. Expressed as a decimal or percentage, this ratio indicates what proportion of a company’s assets are financed by debt.
A ratio greater than 1 implies that a significant portion of a company’s assets are funded by debt, suggesting the company has more liabilities than assets, which could pose a financial risk. Conversely, a ratio below 1 indicates that a larger proportion of a company’s assets are financed by equity.
Key Takeaways
- The debt ratio measures a company’s leverage by comparing total debt to total assets.
- Debt ratios vary widely across industries; capital-intensive businesses usually have higher ratios.
- The debt ratio is calculated by dividing total debt by total assets.
- A ratio over 1.0 indicates more debt than assets, while a ratio below 1.0 implies more assets than debt.
Debt Ratio Formula and Calculation
The formula for calculating a company’s debt ratio is:
Debt ratio = Total debt / Total assets
For instance, if a company has total assets of $100 million and total debt of $30 million, its debt ratio is 0.3 or 30%. The financial health of this company, compared to another with a debt ratio of 40%, depends on the industry in which it operates.
A debt ratio of 30% may be excessive for an industry with volatile cash flows but manageable in a sector with stable cash flows, like utilities.
Advantages and Disadvantages of the Debt Ratio
Pros
- Easy to compute and comprehend, providing a quick overview of a company’s leverage.
- Indicates a company’s capacity to service long-term debt commitments.
- Useful for historical analysis and industry comparison.
Cons
- Doesn’t reveal the nature or cost of debt.
- Not reflective of a company’s profitability.
- Industry comparisons may be misleading due to varying capital needs.
- Lacks forward-looking insight into future business conditions.
Special Considerations
The debt ratio can also reflect total liabilities divided by total assets, highlighting differences in debt and liability concepts. Other key ratios like the debt-to-equity ratio and long-term debt to asset ratio offer additional insights.
In consumer lending, gross debt service ratio and total debt service ratio assess borrower’s repayment abilities, with acceptable total debt service ratios ranging from mid-30% to low-40%.
Debt Ratio vs. Long-Term Debt to Asset Ratio
The debt ratio accounts for both long-term and short-term debts, whereas the long-term debt to asset ratio only considers long-term debts. As a result, the debt ratio is typically higher, providing a more comprehensive view of a company’s liabilities.
Examples of the Debt Ratio
Starbucks
For the fiscal year ending in October 2022, Starbucks had a debt ratio of around 53.6%. Given the capital-intensive nature of the coffeehouse industry, this is lower than the industry average of 75%, allowing Starbucks favorable loan terms.
Meta
Meta reported a debt ratio of 7.9% for the fiscal year ending December 2022. This low ratio is typical in the technology sector where companies can easily raise capital through stock rather than debt.
Common Debt Ratios
- Debt-to-equity ratio: Measures financial leverage by comparing total debt to shareholder equity.
- Long-term debt-to-assets ratio: Focuses only on long-term debt relative to total assets.
- Leverage and gearing ratios: Assess the overall debt levels relative to other financial metrics.
What Is a Good Debt Ratio?
A good debt ratio varies by industry. Generally, a ratio below 1.0 is considered safer, while a ratio of 2.0 or higher is risky. High ratios are common in industries like banking.
What Does a Debt-to-Equity Ratio of 1.5 Indicate?
A debt-to-equity ratio of 1.5 means the company has $1.50 of debt for every $1 of equity. For example, with $2 million in assets and $1.2 million in liabilities, the equity would be $800,000, thus, the debt-to-equity ratio is 1.5.
Can a Debt Ratio Be Negative?
A negative debt ratio implies negative shareholder equity, signaling that the company’s liabilities exceed its assets. This scenario usually indicates significant financial distress and potential bankruptcy risks.
The Bottom Line
The debt ratio is a crucial metric, measuring a company’s leverage as a percentage of total assets. Higher ratios point to significant leverage and potential risk, essential for investors assessing a company’s financial health.
Related Terms: debt-to-equity ratio, financial leverage, long-term debt, total assets, cash flow.
References
- Accounting Tools. “Debt Ratio”.
- United States Department of Agriculture. “Assets, Debt, and Wealth”.
- Servus Credit Union. “What’s My Debt Service Ratio”.
- My Accounting Course. “Long Term Debt to Total Asset Ratio”.
- Starbucks. “Fiscal 2022 Annual Report”, Page 43.
- Starbucks. “Fiscal 2022 Annual Report”, Page 6.
- ReadyRatios. “Eating and Drinking Places: Average Industry Financial Ratios for U.S. Listed Companies”.
- Wall Street Journal. “Meta Platforms Inc”.
- U.S. Securities and Exchange Commission. “Meta Platforms, Form 10-K, For the Fiscal Year Ended December 31, 2022”, Page 85.
- U.S. Securities and Exchange Commission. “Meta Platforms, Form 10-K, For the Fiscal Year Ended December 31, 2022”, Page 102.
