Debt ratio

Definition

The debt ratio, also known as the debt-to-equity ratio, is a financial metric used to assess the proportion of a company’s total liabilities in relation to its total equity.

What is a debt ratio?

A debt ratio provides insights into the extent to which a company is financed by debt versus equity. 

Calculation of debt ratio:

Debt ratio = total liabilities /  total equity​

A higher debt ratio indicates that a larger portion of a company’s assets are financed by debt, while a lower debt ratio suggests that a company relies more on equity financing. Companies with higher debt ratios may be considered riskier to investors and creditors. 

There is no one-size-fits-all ideal debt ratio, as it depends on various factors including the industry, business model, and risk tolerance. What may be considered an acceptable debt ratio for one industry might be considered high for another.

The debt ratio, along with other financial ratios, is typically disclosed in a company’s financial statements. This provides transparency to stakeholders about the company’s capital structure and financial risk.

Can a debt ratio be negative?

A debt ratio can indeed be negative in certain circumstances. This situation occurs when a company has more cash and other liquid assets on hand than its total liabilities. In essence, the number of total liabilities is smaller than the number of total assets minus total liabilities, resulting in a negative value.

This scenario suggests that the company’s financial position is strong, with enough liquid assets to cover all debts and potentially even exceed them. However, negative debt ratios are relatively rare and often occur temporarily due to specific financial events or accounting adjustments.

Common debt ratios

Debt-to-equity ratio: Total debt / Total equity.
This ratio compares the company’s total debt to its shareholders’ equity, indicating the relative proportion of debt and equity financing.

Interest coverage ratio: EBIT / Interest expenses
This ratio indicates how easily a company can pay interest on its outstanding debt from its earnings before interest and taxes (EBIT).

Debt-to-capital ratio: Total debt / (Tota debt + total equity)
This ratio shows the proportion of debt used in the company’s capital structure.

Cash flow to debt ratio: Operating cash flow / total debt
This ratio measures the ability of a company to repay its debt with its operating cash flow.

Example of debt ratio

Let’s consider an example for a fictional company, ABC Ltd.:

Total Debt:

• ABC Ltd. has long-term debt (e.g., bonds and loans) amounting to £500,000.
• Short-term debt (e.g., short-term loans) totals £50,000.

Total debt = £500,000 + £50,000 = £550,000

Total assets:

• ABC Ltd.’s total assets amount to £1,200,000.

Now, using the formula for the debt ratio:​

Debt ratio = £550,000 / £1,200,000 $\approx 0.4583$

In this example, ABC Ltd. has a debt ratio of approximately 45.83%. This means that 45.83% of the company’s total assets are financed by debt.