What it means
Every asset on a balance sheet has been paid for with someone's money, either lent by creditors or contributed and retained by shareholders. The debt ratio shows the split.
A company with $50,000,000 of assets and $30,000,000 of liabilities has a debt ratio of 0.6, an equity ratio of 0.4, and a debt-to-equity ratio of 1.5; the three measures are different views of the same balance sheet, and any one can be derived from the others. The debt ratio is the most intuitive of the three, because it answers a question in plain terms: what fraction of what the company owns does it, in effect, owe?
The ratio's significance is about cushion and obligation. If asset values fall, equity absorbs the loss first, and creditors are only exposed once equity is exhausted.
A company with a debt ratio of 0.4 can lose 60% of its asset value before creditors are affected; one at 0.8 can lose only 20%. Lenders therefore prefer lower ratios and often write a maximum into loan agreements.
From the shareholders' side, liabilities carry fixed obligations, interest and repayment for borrowings, payment on terms for trade creditors, and the higher the ratio, the larger those obligations relative to the business, and the less room there is to absorb a bad year. There is no universally right level.
Industries with stable cash flows and tangible assets, such as utilities, property and infrastructure, run high debt ratios safely, often 0.6 to 0.7 or more, because their earnings reliably cover the obligations and their assets are good security. Businesses with volatile earnings or intangible assets, such as software, consulting and early-stage companies, should run low ratios, because their cash flow may not cover fixed obligations in a downturn and their assets are hard to sell.
Banks are a special case, with ratios above 0.9 by the nature of their business, and are assessed on regulatory capital measures instead. The useful comparison is with peers in the same industry and with the company's own history.
Definitions vary, and the definition must be stated. The broadest version uses total liabilities, including trade payables, accruals, deferred revenue, provisions and lease liabilities.
A narrower version uses only interest-bearing debt, and is sometimes called the debt-to-assets ratio or total debt ratio. The two can differ greatly: a retailer with large trade payables and little borrowing has a high liabilities ratio and a low debt ratio.
Lease accounting has also changed the picture, since leases that were once off balance sheet now appear as liabilities and right-of-use assets, raising the ratio for companies with many leased premises without any change in their economics. Comparisons across time and between companies must be on a consistent basis.
The ratio moves with transactions and with accounting events, and a board managing to a covenant needs to anticipate both. Borrowing to fund an acquisition raises liabilities and assets by the same amount, which raises the ratio; issuing equity to fund it raises assets only and lowers the ratio.
Buying back shares with borrowed money raises liabilities and reduces equity, raising the ratio sharply. A goodwill impairment reduces assets and equity with no cash movement, and can push the ratio through a covenant limit in a year when nothing has changed operationally.
The ratio is a snapshot, and it should be read with the income statement measures of debt capacity, interest cover and debt service coverage, which show whether the obligations can be met from earnings.
In practice
Real-world examples.
Example
A water utility with $2,000,000,000 of assets and $1,400,000,000 of liabilities has a debt ratio of 0.70, considered normal for a regulated business with predictable revenues and long-lived assets.
Example
A consulting firm with $12,000,000 of assets, mostly receivables and cash, and $3,000,000 of liabilities has a debt ratio of 0.25, appropriate for a business whose main asset is its people.
Example
A retailer's debt ratio rises from 0.55 to 0.68 in a single year when new lease accounting rules bring its store leases on to the balance sheet, and its lenders agree to adjust the covenant definition to exclude them.
Think of it
“Debt ratio is like measuring what percentage of your home is mortgaged. Higher percentages mean more of your assets are funded by borrowing.
Formula
Calculation
Debt ratio = Total liabilities / Total assets
Narrow version: Debt-to-assets ratio = Interest-bearing debt / Total assets
Equity ratio = Total equity / Total assets = 1 minus Debt ratio
Debt-to-equity ratio = Total liabilities / Total equity
Worked example. A company has total assets of $50,000,000, total liabilities of $30,000,000 (of which interest-bearing debt is $18,000,000) and equity of $20,000,000.
- Debt ratio = $30,000,000 / $50,000,000 = 0.60
- Debt-to-assets (interest-bearing only) = $18,000,000 / $50,000,000 = 0.36
- Equity ratio = $20,000,000 / $50,000,000 = 0.40
- Debt-to-equity = $30,000,000 / $20,000,000 = 1.5
Effect of transactions on the broad ratio.
- Capitalising $8,000,000 of property leases previously off balance sheet: assets $58,000,000, liabilities $38,000,000; ratio = 0.66, with no change in the business
- Borrowing $5,000,000 to buy back shares: assets stay at $50,000,000 (cash in from the loan, cash out for the shares), liabilities $35,000,000, equity $15,000,000; ratio = 0.70
- Issuing $10,000,000 of shares to fund an acquisition: assets $60,000,000, liabilities $30,000,000; ratio = 0.50
- Borrowing $10,000,000 to fund the same acquisition: assets $60,000,000, liabilities $40,000,000; ratio = 0.67
The same acquisition moves the ratio in opposite directions depending on how it is financed, which is why the funding decision is inseparable from the ratio the board is prepared to carry.Case study
Seen in the real world.
A manufacturing company's bank facility carried a covenant that the debt ratio, defined as total liabilities to total assets, must not exceed 0.65. The company stood at 0.60 with assets of $50,000,000 and liabilities of $30,000,000, and its board approved a $12,000,000 acquisition of a competitor, to be funded entirely by an increase in the bank facility. The finance director's pre-completion check showed the problem: after the deal, assets would be $62,000,000 and liabilities $42,000,000, a ratio of 0.68, an immediate breach on completion.
The structure was changed. The company raised $4,000,000 of equity from its existing shareholders through a rights issue and borrowed $8,000,000.
Post-deal assets were $62,000,000 and liabilities $38,000,000, a ratio of 0.61, leaving four points of headroom. The bank accepted the structure, and the acquisition completed.
The headroom proved necessary a year later for a reason nobody had modelled. The acquired business underperformed, and the annual impairment review required $6,000,000 of the goodwill paid to be written off. The write-off involved no cash, but it reduced assets to $56,000,000 and equity by the same amount, while liabilities stayed at $38,000,000: a ratio of 0.68, and a breach after all.
The board negotiated a waiver, at a cost of a fee and a higher margin, and applied the year's profits to repaying $5,000,000 of the loan, taking assets to $51,000,000 and liabilities to $33,000,000, a ratio of 0.65, back inside the limit. The finance director's lesson for the board was that the debt ratio responds to accounting as well as to cash, that acquisitions carry the specific risk of impairment on the balance sheet as well as the risk of underperformance in the income statement, and that headroom under a balance sheet covenant should be sized for both.
Watch out
Common mistakes.
- Comparing debt ratios calculated on different definitions, such as total liabilities in one case and interest-bearing debt in another, which are not comparable and can differ by half.
- Judging the ratio without reference to the industry; 0.7 is normal for a utility and alarming for a software company.
- Ignoring non-cash movements such as impairments and lease capitalisation, which change the ratio without any change in the business and can breach covenants unexpectedly.
Questions
People also ask.
What is the difference between the debt ratio and the debt-to-equity ratio?
The debt ratio divides liabilities by total assets; the debt-to-equity ratio divides liabilities by equity. They express the same balance sheet in different terms: a debt ratio of 0.6 is a debt-to-equity ratio of 1.5, and a debt ratio of 0.5 is a debt-to-equity ratio of 1.0.
Is a low debt ratio always better?
Not for shareholders. A company with very little debt may be forgoing cheap, tax-deductible capital and earning a lower return on equity than it could. The right level balances the benefit of leverage against the risk of distress, and depends on the stability of the business.
What debt ratio do lenders require?
It varies by lender and industry, and the definition in the loan agreement governs. Covenants for ordinary trading companies are often set between 0.6 and 0.75 on total liabilities, with lower limits on interest-bearing debt. Lenders also test interest cover and debt service coverage, which measure the ability to pay rather than the balance sheet cushion.
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