Debt level ratios are useful first steps in understanding a firm's capital structure. Knowing how much of a company's assets are financed by debt is most revealing when compared to companies in the same industry. However, accounting policy can distort debt ratios; therefore, more analysis is necessary before drawing conclusions from a debt ratio formula. Two common ratios used for looking at corporate debt levels are the total debt ratio and the debt-equity ratio.
The debt-equity ratio is computed by dividing a firm's total debt by its shareholders' equity, which represents what shareholders would get after debts were paid off if the firm were liquidated. The total debt ratio is computed by dividing total liabilities by total assets.
Understanding the Debt-Equity Ratio
The debt-equity ratio of a firm measures a company's capital structure. Calculating debt-equity ratio is accomplished by taking the total corporate debt and dividing it by the firm's total equity. For example, if a company has long-term debt of $100 million and total equity of $278 million, the debt-equity ratio of the firm is 36 percent. Of note, industries often have debt-equity ratio norms; therefore, investors may wish to compare ratios of firms operating in the same sectors.
A company's shareholder equity and total liabilities are listed on its balance sheet. For publicly traded companies, this is usually shared in regular filings with the Securities and Exchange Commission and available through financial data sites, corporate investor relations departments and brokerages.
Understanding the Total Debt Ratio
The total debt ratio compares the total liabilities with the total assets of a firm. It's also referred to as the debt to asset ratio. Total assets and total liabilities are published on a company's balance sheet.
Unlike the debt-equity ratio, short-term assets and liabilities are factored into the equation. The calculation is straightforward, the firm's total liabilities are divided by total assets. This ratio measures the percent of the company's assets financed with debt. For example, a business with a total debt ratio of 75 percent has effectively financed three fourths of the firm's assets utilizing debt.
Forecasting Financial Stress with Ratios
The total debt and debt-equity ratios might signal a firm will face financial difficulty in the future. Firms with high debt ratios may incur significant interest payments that reduce profits. Interest expense can also shrink the cash available for growth-oriented activities such as research and development. In addition, a firm with high debt ratios may have difficulty raising capital because potential investors might conclude the company's bankruptcy risk is too high to justify investment.
Moving Beyond Debt Ratios
Debt ratio analysis should be a starting point for evaluating a firm's performance. Deeper research into factors driving the capital structure is needed to properly evaluate the company's finances. Investors should be aware that accounting policies could skew debt ratios, and managers sometimes also may manipulate liabilities or assets in order to produce favorable debt ratios. Investors inspecting debt ratios should thoroughly review the accounting decisions described in the important changes to accounting policy section of companies' annual reports.
Remember also that debt ratio levels vary between industries. Some retail companies may have high liabilities thanks to buying goods on credit or taking out leases for stores, for example, which may not endanger investors since they will pay this debt off over time. Manufacturing companies also often operate with relatively high debt ratios. If interest rates are low, it can also make sense to borrow money cheaply to expand operations.
Companies that are doing well but are concerned about high debt ratios might use revenues to pay debts down early as a way to reassure investors, raise credit ratings and cut financing costs.
Kevin O'Flynn began writing in 2008 with a background in private equity. He has written for MilitarySpot.com and lived and worked in the United Kingdom and Japan. O'Flynn holds a Master of Business Administration from Case Western Reserve University.