Debt Ratios

By Investopedia | Updated June 13, 2017 — 4:23 PM EDT

1. Debt Ratios: Introduction

2. Debt Ratios: Overview Of Debt
3. Debt Ratios: The Debt Ratio
4. Debt Ratios: Debt-Equity Ratio
5. Debt Ratios: Capitalization Ratio
6. Debt Ratios: Interest Coverage Ratio
7. Debt Ratios: Cash Flow To Debt Ratio

Debt Ratios: Introduction

A company’s debt ratio is the ratio of total debt to total assets. Total debt includes both short-
term and long-term debt. There are several debt ratios, which give users a general idea of the
company's overall debt load as well as its mix of equity and debt.

Debt ratios can be used to determine the overall level of financial risk a company and its
shareholders face. In general, the greater the amount of debt held by a company, the greater
the potential level of financial risk the company could face, including bankruptcy.

Debt is a form of financial leverage. The more levered a company is the greater the level of
financial risk. On the other hand, a certain amount of leverage can contribute to a company’s
growth. Well-run companies seek an optimal amount of financial leverage for their situation.

Debt Ratios: Overview Of Debt

In the business world, debt is the amount that a business owes creditors. The most common
forms of corporate debt are loans from banks and other lenders, as well as corporate or
government bonds.

Debt is part of the liability section of a corporate balance sheet. Creditors have a claim on the
company’s debt. Liabilities are obligations of the company, so failure to make good on these
obligations could result in bankruptcy.

There are two types of liabilities — operational and debt. Operational includes balance sheet
accounts, such as accounts payable, accrued expenses, taxes payable, pension obligations,
etc. The latter includes notes payable and other short-term borrowings, the current portion of
long-term borrowings, and long-term borrowings. In most investment literature, "debt" is used
synonymously with total liabilities. In other instances, it only refers to a company's actual
indebtedness.
The debt ratios that are explained in the following sections are those that are most commonly
used. However, what companies, financial analysts and investment research services use as
components to calculate these ratios is far from standardized.

Investors may want to look to the middle ground when deciding what to include in a company's
debt position. With the exception of unfunded pension liabilities, a company's non-current
operational liabilities represent obligations that will be around, at one level or another, forever—
or at least until the company ceases to be a going concern and is liquidated.

Also, unlike external debt, there are no fixed payments or interest expenses associated with
non-current operational liabilities. In other words, it is more meaningful for investors to view a
company's indebtedness and obligations through the company as a going concern, and
therefore, to use the moderate approach to defining debt in their leverage calculations.

Debt Ratios: The Debt Ratio

The debt ratio compares a company's total debt to its total assets. This provides creditors and
investors with a general idea as to the amount of leverage being used by a company. The lower
the percentage, the less leverage a company is using and the stronger its equity position. In
general, the higher the ratio, the more risk that company is considered to have taken on.

The debt ratio is calculated as follows:

Total Liabilities divided by Total Assets

If a company has $1 million in total liabilities and $3 million in total assets this means that for
every dollar the company has in assets, it has 33 cents worth of liabilities.

If a company has $2 million in total liabilities compared to $3 million in total assets this means
that for every dollar of assets the company has 67 cents worth of liabilities.

What does the debt ratio tell us?

The debt ratio tells us the degree of leverage used by the company.

If a company has a high debt ratio (the definition of high will vary by industry) this is an
indication that the company must commit a significant portion of its ongoing cash flow to the
payment of principal and interest on this debt.

On the other hand, a company that employs very little debt, especially if this is low compared to
other companies in the same industry, may not be properly using leverage that might increase
its level of profitability.

For example, utilities generally have a higher debt ratio than companies in many other industries
due to the capital-intensive nature of the utility business.

Users of this data need to look beyond the ratio to determine what makes up the company’s
liabilities. Items such as trade payables and goodwill might be excluded to provide a more
accurate picture of the company’s long-term debt burden compared to their assets.
Debt Ratios: Debt-Equity Ratio

The debt-equity ratio is another leverage ratio that compares a company's total liabilities to
its total shareholders' equity. This is a measurement of the percentage of the company’s
balance sheet that is financed by suppliers, lenders, creditors and obligors versus what the
shareholders have committed.

The debt to equity ratio provides another vantage point on a company's leverage position, in
that it compares total liabilities to shareholders' equity as opposed to total assets in the debt
ratio. Similar to the debt ratio, a lower percentage means that a company is using less
leverage and has a stronger equity position.

The ratio is calculated by dividing the company’s total liabilities by its shareholder’s equity.

Like the debt ratio, this ratio is not a pure measurement of a company's debt because it
includes operational liabilities as part of total liabilities.

Additionally, what constitutes a “good” or “bad” result will vary by industry. For example, an
industry such as telecommunications and other types of utilities require substantial up-front
and frequent ongoing capital investment.

These expenditures are often financed by borrowing so, all else being equal, their debt-
equity ratio would be on the high side.

Utilities generally have a high level of debt because they can. Most electric utilities are
virtual monopolies and have little or no competition. Unless the population in their service
area were to rapidly decline, they can assume pretty stable revenues and cash flows, so
they know with a high level of certainty how much they will have to service their debt on an
ongoing basis.

The banking industry is another area with typically high levels of debt to equity. They use
borrowed money to make loans at higher rates of interest than they are paying for the funds
they borrow. This is one of the ways they make a profit.

The real use of debt-equity is in comparing the ratio for firms in the same industry. If a firm’s
debt-equity ratio varies significantly from its competitors or the averages for its industry, this
should raise a red flag. Companies with a ratio that is too high can be at risk for financial
problems or even a default if they can’t meet their debt obligations.

On the other hand, companies employing too little leverage may be earning less than their
competitors as a result.

Debt Ratios: Capitalization Ratio

The capitalization ratio measures the debt component of a company's capital structure,
defined as the mix of debt (liabilities) and shareholder’s equity on the company’s balance
sheet. This is the means that the company uses to finance its operations and any capital
spending.

Debt vs. Equity

Debt and equity are the two main methods a company can use to finance its operations.

Debt has some advantages. Interest payments are tax deductible. Debt also doesn’t dilute
ownership of the firm like issuing additional stock does. When interest rates are low, access
to the debt markets is easy and there is money available to lend.

Debt can be long-term or short-term and can consist of bank loans of the issuance of
bonds.

Equity can be more expensive than debt. Raising additional capital by issuing more stock
can dilute ownership in the company. On the other hand, equity doesn’t have to be paid
back.

A company with too much debt may find its freedom of action restricted by its creditors
and/or have its profitability hurt by high interest costs. The worst of all scenarios is having
trouble meeting operating and debt liabilities on time during adverse economic conditions.
Lastly, a company in a highly competitive business, if hobbled by high debt, will find its
competitors taking advantage of its problems to grab more market share.

The capitalization ratio is one of the more meaningful debt ratios because it focuses on the
relationship of debt liabilities as a component of a company's total capital base, which is the
capital raised by shareholders and lenders.
Debt Ratios: Interest Coverage Ratio
The interest coverage ratio is used to determine how easily a company can pay their
interest expenses on outstanding debt. The ratio is calculated by dividing a company's
earnings before interest and taxes (EBIT) by the company's interest expenses for the same
period. The lower the ratio, the more the company is burdened by debt expense. When a
company's interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses
may be questionable.

The ratio measures how many times over a company could pay its outstanding debts using
its earnings. This can be thought of as a margin of safety for the company’s creditors should
the company run into financial difficulty down the road.

The ability to service its debt obligations is a key factor in determining a company’s
solvency and is an important statistic for shareholders and prospective investors.

Investors want to be sure that a company they are considering investing in can pay its bills,
including its interest expense. They don’t want the company’s growth derailed by these
types of financial issues.

Creditors are concerned with the company’s ability to make their interest payments as well.
If they are struggling to make the interest payments on their current debt obligations, it
doesn’t make any sense for a prospective credit to extend them additional credit.

Trends over time

The interest coverage ratio at a point in time can help tell analysts a bit about the
company’s ability to service its debt, but analyzing the interest coverage ratio over time will
provide a clearer picture of whether or not their debt is becoming a burden on the
company’s financial position. A declining interest coverage ratio is something for investors
to be wary of, as it indicates that a company may be unable to pay its debts in the future.
However, it is difficult to accurately predict a company’s long-term financial health with any
ratio or metric.

Moreover, the desirability of any particular level of this ratio is in the eye of the beholder to
an extent. Some banks or potential bond buyers may be comfortable with a less desirable
ratio in exchange for charging the company a higher interest rate on their debt.

Debt Ratios: Cash Flow To Debt Ratio

This coverage ratio compares a company's operating cash flow to its total debt. Operating cash
flow is defined as the amount of cash generated by the company’s normal business operations.

As an example, take a manufacturing company that reports a net income of $100 million, with
an operating cash flow of $150 million. The difference comes from adding to the net income
depreciation expense of $150 million, subtracting increases in accounts receivable of $50
million, adding decreases in inventory of $50 million and subtracting decreases in accounts
payable of $100 million.

Depreciation is an expense for accrual accounting purposes, but there is no cash outlay so it is
added back to reported net income. Increases in accounts receivables denote increased
revenues but result in no actual cash inflows, hence they are subtracted. A decrease in
inventories would indicate that less money had been spent adding to inventories, hence the
increase in cash flow. An increase in inventories would have been a reduction in cash flow. The
decrease in accounts payables means that the firm paid down some of its payables, which is a
use or reduction of cash.

Debt is the sum of short-term borrowings, the current portion of long-term debt and long-term
debt.

This ratio provides an indication of a company's ability to cover total debt with its yearly cash
flow from operations. The higher the percentage ratio, the better the company's ability to carry
and service its total debt.

Read more: Debt Ratios: Cash Flow To Debt

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