What Is the Debt Ratio?

What Is the Debt Ratio?

Let me explain the debt ratio to you directly—it's a financial metric that shows a company's leverage by comparing its total debt to its total assets, expressed as a decimal or percentage. This ratio tells you what portion of the company's assets is financed through debt, which is crucial for understanding its financial health. If the ratio is greater than 1, that means the company has more liabilities than assets, indicating a heavy reliance on borrowing. A high ratio like that could put the company at risk of default if interest rates spike suddenly. On the other hand, a ratio below 1 shows that more of the assets are funded by equity, which is generally safer.

Key Takeaways

Here's what you need to remember about the debt ratio: it measures how much of a company's funding comes from borrowing, and it varies a lot across industries—capital-intensive ones like utilities often have higher ratios than tech firms. You calculate it by dividing total debt by total assets. If it's over 1.0 or 100%, the company has more debt than assets; if under 1.0, it has more assets than debt. Keep in mind that some sources use total liabilities instead of just debt in the calculation.

Debt Ratio Formula and Calculation

As I mentioned, the debt ratio gauges a company's financial leverage, and it differs widely by industry—think utilities with high ratios versus tech companies with lower ones. The formula is straightforward: debt ratio equals total debt divided by total assets. For example, if a company has $100 million in assets and $30 million in debt, the ratio is 0.3 or 30%. Whether that's good or bad depends on the industry. A 30% ratio might be too high in a sector with unstable cash flows where companies avoid much debt, making borrowing expensive and risky during changes. But in stable sectors like utilities, even 40% could be manageable with steady cash flows.

Advantages and Disadvantages of the Debt Ratio

Let's talk about the pros first. The debt ratio is simple to calculate and understand, giving you a quick view of a company's debt versus its assets—what it owes compared to what it owns. Since public companies report this data regularly, it's easy to access. It helps you figure out if a company can handle its long-term debt; a lower ratio means it's more stable and less likely to go insolvent. You can use it to compare companies in the same industry or track changes over time against benchmarks, aiding investment decisions based on historical data.

Now, the downsides. It doesn't tell you about the types of debt or their costs—different terms and interest rates can hugely impact stability. It relies on accounting data that might be manipulated. It ignores profitability; a company with high leverage but strong earnings from assets might be fine, while low returns could make even a low ratio risky. Comparing across industries isn't always fair because capital needs vary—some sectors require high debt for investments. Finally, it's a snapshot in time, so changes like acquisitions or asset sales can alter it quickly, and relying only on historical ratios without future outlooks can mislead you.

Special Considerations

Be aware that some define the debt ratio as total liabilities divided by total assets, which introduces ambiguity since liabilities include more than just debt. The related debt-to-equity ratio uses total liabilities too and is more common. Financial providers often calculate it using only short- and long-term debt, excluding things like accounts payable. In lending, ratios like gross debt service (monthly housing costs over income) and total debt service (including other debts) are used, with acceptable levels in the mid-30s to low-40s percent. Remember, a higher debt ratio means more leverage and risk, but leverage is a tool for growth that many companies use sustainably.

Debt Ratio vs. Long-Term Debt to Assets Ratio

While the debt ratio includes all debts, the long-term debt to assets ratio only considers long-term ones. The debt ratio covers both long-term like mortgages and short-term like utilities or loans due soon. Both use all assets, tangible and intangible. Because it includes more liabilities, the debt ratio is usually higher than the long-term version.

Examples of the Debt Ratio

Take Starbucks—for fiscal year 2022, it had $1.92 billion in short-term debt and $13.1 billion in long-term, totaling $15 billion debt against $28 billion assets, giving a 53.6% ratio. Considering costs like leasing, renovations, equipment, training in a high-turnover industry, and regulations for 18,253 stores, this isn't bad—industry average was 79%, so borrowing was easy for them.

Now Meta, formerly Facebook, reported $26.59 billion debt and $185.7 billion assets in 2022, for a 14.3% ratio. They borrowed $10.5 billion for things like AI investments.

Common Questions About Debt Ratios

You might wonder about other common debt ratios—they include debt-to-equity, debt-to-assets, long-term debt-to-assets, and leverage or gearing ratios. A good debt ratio depends on the business and industry; below 1.0 is safe, above 2.0 risky, with sectors like banking having higher norms. A debt-to-equity of 1.5 means $1.50 debt per $1 equity—for example, $2 million assets and $1.2 million liabilities give $800,000 equity, ratio 1.5. Yes, a negative ratio is possible if debt exceeds assets, signaling bankruptcy risk.

The Bottom Line

In summary, the debt ratio measures total debt as a percentage of total assets, showing if a company is highly leveraged and at risk of not repaying. You and investors use it to gauge default risk.