Debt Ratio as a Measure of Financial Health
Debt ratio is an indicator of the amount of debt of a company, compared to its assets. It shows to investors, financial institutions, and other parties whether a business has loans and how much. A high ratio indicates that the company is a risky borrower while a low ratio shows that the business has a conservative approach to financing. It increases the chances of getting approved for a business loan.
Formula and Calculations
The ratio shows the total assets and liabilities of a business. It is an indicator of the amount of assets and operations of a company that are financed through loans. The liabilities of a business cover its non-current and current liabilities. The latter include debts to employees and suppliers, short-term bank loans, prepayments, and taxes. Examples of non-current liabilities are pension liabilities, long-term bank loans, bonds, and capital leases. All these liabilities should be added to come up with a figure that shows the total liabilities of a company. The next step is to calculate them. There are current assets which are fairly liquid because they can be converted into cash within a period of one year. Examples of such assets are inventory, cash, accounts receivable, short-term investments, and marketable securities. The non-current assets are fairly illiquid because their cost is allocated over a longer period of time. One example is restricted cash that cannot be used or withdrawn to finance the company’s normal operations. Other examples include receivables that are not due within a period of 1 year, depreciable assets, and land. Other assets such as goodwill are also included. All current and non-current ones should be added to calculate the total assets of a company. Then the debt ratio is calculated by dividing the total liabilities of the firm by its total assets.
How to Read the Ratio
The ratio is in the range of 0 to 1. If it is greater than or equal to 0.5, the company uses external financing (loans) to fund its assets. When the ratio is less, the company uses equity to finance its assets. The maximal normal value is in the range of 0.6 to 0.7. However, this depends on the sector and industry in which the company operates. It also depends on the percentage of non-current and current assets. Companies that have more non-current assets use more of their equity to fund their operations, investments, and expansions. The reason is that non-current assets take more time to convert into cash.
The debt ratio is an indicator of the ability of businesses to pay their outstanding balances. It is a measure of financial health. Thus, investors and creditors prefer companies with low ratios while those with large amounts of debt are often unable to raise capital.
Example
If the total liabilities of a business are $255,850 and the total assets are $675,200, the ratio is 0.378 ($255,850/$675,200) or 37.8 percent. If the total assets are $518,000, the non-current liabilities are $230,000, and the current liabilities - $57,000, the ratio is 0.554 (($230,000 + $57,000)/$518,000) or 55.4 percent. The second company presents more risk because its ratio is higher than 0.5. When the figure is greater than 1, this means that the business has more liabilities than assets. A ratio of less than 1 shows that the firm has less debt than assets.
Other Tools to Measure Financial Health
This is a useful indicator for investors who assess financial health to see whether it is a good option to invest in stock. Naturally, financial institutions and investors use other tools such as creditworthiness, payment history, income level, and others. Banks look at the total amount of debt, types of loans, missed and late payments, delinquencies, and so on. Another tool is the debt to equity ratio which is calculated by dividing the total liabilities of a business by the shareholders’ equity. This is an indicator of the portion of external financing and equity a business uses to fund its assets and operations. In some cases, the formula includes only long-term, interest-bearing obligations rather than the total liabilities. The formula can be applied to business and personal financial statements. Generally, a high debt to equity ratio means that a firm has taken an aggressive approach and has excessive debt. There is a higher risk that the company will default or file for bankruptcy, especially if it uses external financing for investment. The ratio depends on whether the company is in a capital-intensive industry that requires significant financial resources to produce services or goods. Examples include manufacturing, transportation, telecommunications, and oil refining. Capital intensive industries have a ratio of 2 and above while computer companies and businesses in other sectors have a ratio of less than 0.5.
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