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.
The debt-equity ratio of a firm measures a company's capital structure. Calculating debt-equity ratio is accomplished by taking the total long-term 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 should only compare ratios of firms operating in the same sectors.
Total Debt Ratio
The total debt ratio compares the total liabilities with the total assets of a firm. 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 financed three fourths of the firm's assets utilizing debt.
Forecasting Financial Stress
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.
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. Managers sometimes 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.
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