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If you were having trouble understanding what debt ratios are, then you are in the right place. Even though this term may appear difficult to understand, it is actually pretty easy and friendly. Today you’ll learn more about it, what it means, how you calculate it or how to apply it in your daily routine.
What Are Debt Ratios?
Debt Ratios indicate a percentage of one’s debts divided by assets. It can also show a ratio of total liabilities divided by total assets. Let’s just take an example to make it even easier to understand: if you have a company with pending payments of $200 and you’re selling a single product for $50, then you still have a ratio of 25%. It is important to keep in mind that this term applies to companies, since for individuals it is called debt-to-income ratio, but we’ll talk more about this in another post.
There are two ways in which ratios can be calculated. The first one divides the total debts to the total assets, while the alternative is to divide total liabilities to total assets.
Debt Ratio =Total Debts/Total Assets Debt Ratio =Total Liabilities/Total Assets
The total liabilities divided by total assets show how many of the company’s assets are financed through debt. The higher the ratio is, the more assets are financed by debt. A business is financed through equity as long as the ratio has a value of 0.5 or lower.
Interpretation Of Debt Ratios
On one hand, this method of calculation is mostly used by investors when considering a company’s profitability. This ratio provides valuable information regarding the organization’s debt amount compared to assets. A high percentage will show that the company is risky, making it more leveraged.
On the other hand, there are many large companies with high debt ratios that are very successful. Take IBM as an example, they had 69% in 2005 and they still are a powerful company worldwide. If the organization can generate high returns above their costs and expenses, then investors will receive plenty of benefits. However, the use of leverage can be a Russian roulette for companies, since it magnifies both gains and losses.
Effects Of Debt Ratios
What we know for sure is that when a business has high debts it becomes no longer trusted by banks or financers, due to the fact that its operation is at stake.
Imagine that you own a bank that supports businesses to grow. You accept applications from businesses that have a strong income and who can guarantee for paying back the credit.
However, a company with high ratios applies for a credit, but they show more debts than incomes. This may be just a temporary issue in case their industry is going through a rough time, or it could be a long-term situation, showing that the company’s success on the market is not fulfilled.
Types of Debt Ratios
The Debt-equity ratio shows the total liabilities divided by shareholder’s equity. It is another leverage ratio that compares shareholders involvement to how much creditors, suppliers or lenders have committed.
Debt-Equity Ratio = Total Liabilities/Shareholder's Equity
Lower percentages of debt-equity ratio also show that the company uses less leverage, having a more powerful equity position. Compared to the regular ratios, this percentage shows a heavier perspective regarding the organization’s leverage position.
If we take IBM’s example, their debt-equity ratio was of 220%, which is a lot higher and more dramatic than 69%. Moreover, it shows that equity holders have less money in the company compared to creditors.
However, they are one of the strongest companies worldwide, so why worry? Large companies will always have higher flexibility in pushing the liability component to higher ratios.
These companies will always have a high return to cover all expenses and debts.
The capitalization ratio calculates the long-term debt divided by the sum of shareholders’ equity and long-term debt. Sounds quite complicated, right?
Well, this is actually considered among the most meaningful ratios, since it provides a clear image on the company’s use of leverage.
Capitalization Ratio = Long-term debt/(Shareholder's equity+Long-term debt)
This ratio is actually an indicator of financial stability for a company’s financial structure. Using leverage wisely can help a company expand and develop.
This is why this formula shows the necessity of a company to keep solid compliance with financial commitments. The capitalization ratio shows the connection between debt liabilities, as a total capital base component.
Interest Coverage Ratio
This percentage shows the ease of a company to pay its interests and taxes divided by interest expense. Does it sound too complicated?
This is actually a big subject when it comes to a company’s financial status and balance sheet. Let’s take a look at the formula.
Interest Coverage Ratio = Earning before interest and taxes/Interest expense
Now, this seems a bit clearer. We all try to avoid paying high interests and taxes on credits that we take from banks, right?
This is similar to companies as well, since prudent borrowing is highly desired. An organization’s profitability can be affected if the interests paid are too high, since they take out from the profit.
The interest coverage ratio can indicate both additional debt capacity and a positive effect of funding the company. To make it simpler, creditors have more trust in a company that knows how to handle the interest ratio, since it shows deep knowledge of service debt handling.
Cash Flow to Debt Ratio
This is one of the most used ratios by companies worldwide. Actually, individuals use the same strategy when calculating their personal finance. Dividing the operating cash flow to the total debt can indicate any short-term borrowings needed.
Cash Flow to Debt Ratio = Operating Cash Flow/Total Debt
Investors and Creditors know a company’s ability to cover debt depends on this percentage ratio: the higher, the better. High percentages show financial strength, while low ratios can indicate too much debt or poor cash flow.
However, the factors behind must be considered when a company shows low rates. Doing this will involve comparing the cash flow history to the debt ratios in order to identify any warning signs.
Advantages Of Debt Ratios
- Debt financing can allow investing in new assets that will develop the business
- Increase growth and development strategies
- Pay off debts over long period of time
- Not giving up to business ownership
Debt ratios can increase the partnership with new investors by sharing the risks and liabilities. The generated cash flow can also be used to grow the organization and to expand it to new areas.
Also, keeping a low percentage of debt-to-equity will increase the chances of getting a loan in the future.
Disadvantages of debt Ratios
- Pay back the full debt plus interests
- Assets exposed to bank ownership
- Reduces profit through paying the debt using earnings
- Limitation of cash flow when using debts in excess
Companies give up a part of the ownership when taking on equity investments. If the organization will go through an important period in which big decisions should be taken, then this decision will also have to be made by investors. In addition, if the company reaches a golden point where the business is fast developing, then a portion of the earnings will have to go to investors. Therefore, it is very important to choose the right strategy when taking loans.
Now that we established some of the most important details regarding debt ratios, we can simply draw some basic conclusions. First, the use of leverage is very important and companies must always plan everything ahead, to avoid any financial risks. Second, it may seem a good idea to apply for a loan when expanding the business, but is it profitable on the long term? Third, a company’s ownership would be divided to multiple stakeholders. Even though it is recommended to have a low ratio, large companies may show the opposite. However, it is mandatory to remember that strong strategies can build empires and reduce any financial risks.