The debt ratio indicates the level of indebtedness of a company. It represents the proportion of liabilities (debts) compared to the net worth of an entity. This ratio is crucial for measuring the level of leverage and financial risk. It helps us evaluate a company’s ability to take on and manage its debt.
HOW TO CALCULATE THE DEBT RATIO / FORMULA
Debt can be found in the liabilities section of the balance sheet, which includes all short-term and long-term payments that the company must face.
The debt ratio indicates the percentage of total debt that a company supports in relation to its contributed capital or own funds. For this, we use the data from the balance sheet: liabilities and net worth.
Total Liabilities: Short-term liabilities + long-term liabilities
Net Worth: Contributed capital + accumulated profits + undistributed profits. That is, the money contributed to the company.
The purpose of calculating the debt ratio is to measure how the company is financed: With Own Resources (net worth) OR With External Resources (debt)
INTERPRETATION OF THE DEBT RATIO
The debt ratio is a financial indicator that measures how much debt we have in relation to how much money we have contributed to the company’s equity. For example, if we have a debt ratio of 1.5, the company is in a risky situation, since for every euro of equity it owns, it has 1.5 euros of debt. In other words, it owes more than it owns.
A high ratio may indicate a high level of leverage, which can pose a high risk. On the other hand, a very low ratio may suggest a lack of leveraging opportunities for investment.
WHAT IS THE IDEAL DEBT LEVEL?
Debt > 1 ➜ Equity Imbalance Debt
between 0.6 and 1 ➜ High Debt Debt
between 0.4 and 0.6 ➜ Medium Debt.
Optimal value Debt < 0.4 ➜ Low debt, idle capital
If the result of the ratio is greater than 1:
the company has an equity imbalance since it has more debts than capital.
If the ratio is between 0.6 and 1:
it means that your business has high indebtedness. We must be alert to the risk we are assuming.
Debt between 0.6 and 0.4:
If it is between 60% and 40%, the level of indebtedness is balanced.
Debt < 0.4:
The company may be incurring unproductive resources by not using that money in investing in opportunities that could yield a return.
In any case, we cannot just look at the result of this ratio; it is important to see the situation in which the company finds itself and in which sector it operates.
Since there are some sectors, like construction, that can present high indebtedness while carrying out promotions, but ultimately be quite profitable, and industrial companies often justify higher indebtedness, especially those with a long manufacturing period.
PRACTICAL EXAMPLES:
Example 1:
Total Liabilities: €500,000
Net Worth: €1,000,000
Debt Ratio: 500,000 / 1,000,000 = 0.5
The company has manageable debt compared to its equity. A ratio of 0.5 indicates a moderate level of leverage, which can be positive for its growth if the company needs capital to expand.
Example 2:
Total Liabilities: €10,000,000
Net Worth: €5,000,000
Debt Ratio: 10,000,000 / 5,000,000 = 2
Interpretation: A ratio of 2.0 implies that the company has twice as much debt as equity. This can be a warning sign, indicating an excessive dependence on debt, which could increase its vulnerability to market fluctuations, interest rates, or in an economic crisis.
TYPES OF DEBT RATIOS:
To analyze the financial health of the company, the short-term and long-term debt ratios are usually used, with which we can analyze DEBT QUALITY.
DEBT QUALITY
We measure the amount of debt that corresponds to be repaid in the short term and in the long term.
Short-term debt = Current liabilities / Total liabilities
If the short-term debt quality <= 0.5 it’s okay
A value less than or equal to 0.5 indicates good debt quality.
Long-term debt = non-current liabilities / Total liabilities
The more short-term debt we have, the higher the risk of insolvency and liquidity problems. Ideally, we should seek to minimize short-term debt. It is desirable that the short-term debt ratio is as low as possible, as this would make it easier to repay debts in the short term.
The longer we have to pay our debt, the higher the quality of debt we have.
Since, if we have high indebtedness, but it is long-term, the financial stability of the company will be greater as it has more time to repay it, and usually, the cost of long-term debt is lower.
If we must repay it in the short term, it will cause treasury tensions.
However, it is better to compare the debt with the company’s profit.
Banks look a lot at the debt/EBITDA ratio. They usually ask for a maximum of 3.4.
It is also advisable to compare the size of the debt with the net profit, the best way to see the debt if it is much or little is to see if we can pay the interest (interest vs. EBIT) and if we can repay the principal (profit against debt).
WHEN IS IT ADVISABLE TO REQUEST FINANCING?
When the profitability is greater than the cost of the debt.
Example: If the loan costs us 5% interest, but we increase the profitability of the business thanks to leverage by 25%. We have obtained a 20% more profit.
But as we have more debt, the cost of the debt will become more expensive until it may happen that the cost of the debt is greater than the increase in ROE. In that case, it will not be convenient to request more debt.
HOW MUCH MAXIMUM DEBT SHOULD WE HAVE?
The one we can pay principal and interest in one or several bad years. Banks usually ask for a maximum debt/EBITDA ratio of at least 4. And an interest coverage ratio EBIT / interest of more than 3.
TIPS:
Forecasting: Before applying for a loan, make projections of your results and balance sheet. This will help you determine how much and when to ask. In addition, this will improve your negotiating power with the bank.
Comparison: Compare your debt with companies in the same sector to see if it is high or low.
Maturities: Ensure that the term to repay your debt is long enough, even considering unfavorable scenarios.
Cash Flow Analysis: Look at the size of the CFO (profit + depreciation) in regular and unfavorable years. Compare this with future investments and see how much money is left to repay the loan.
Working Capital (WC): Maintain a solid WC that provides solid and permanent financing to the company.
Relationship with the Bank: It is preferable to have a long-term loan instead of having to go to the bank to renew every year.
CONCLUSION:
If we have high indebtedness, we may be in an economic risk situation due to changes in the country’s economic situation, the market, and in crisis situations, financial entities will be more reluctant to grant us financing.
On the other hand, indebtedness can be our fast track to growth and expansion. That is why the debt ratio is key to being able to see the degree of solvency in terms of the company’s financial capital.
