What is a Debt Ratio?

The debt ratio measures the proportion of assets that are financed by debt. It is calculated by dividing total debt by total assets.¹

What does the Debt Ratio indicate?

A company can raise two types of capital: debt and equity. Debt capital requires a fixed rate of interest payment whereas equity owners are rewarded based on the performance. Irrespective of how the company performs, the interest to debt holders needs to be made. This is why debt is considered to be risky whereas equity can be a form of risk-free capital. A high debt ratio would mean more interest payments to the debt providers. If the company is not able to generate sufficient returns, it can default on its interest payments.

So, why does a company take debt? When equity providers are not guaranteed a fixed rate, the investors demand a higher return which can be more than the interest rate. To bring down the cost of capital, a company needs to issue debt. The debt ratio helps keep a check on the amount of debt the company has taken and can be calculated with the following formula.²

Debt Ratio = Total Debt / Total Assets

One can compare the debt ratio to the industry standards in order to determine how the company is performing. The debt ratio over a period of time should also be checked in order to understand the capital structure.

Example

Company ABC is a leader in the communication space. The company has assets worth $100 billion that are financed with $50 billion of debt. The industrial average for debt ratio is 0.60. Company ABC is planning to raise an additional $60 billion in debt to finance its capital expenditure. Initially, the debt ratio for the company was 0.50 (50/100) but after raising new capital the ratio would increase to 0.69 ((50+60)/(100+60)). This is above the industrial average and it is recommended that the company raise a fraction of the capital from equity.

References

1.  "Debt Ratio Formula." Wall Street Mojo. https://www.wallstreetmojo.com/debt-ratio/

2. "Debt Ratio." Investopedia. https://www.investopedia.com/terms/d/debtratio.asp

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