Debt ratio: How to calculate and interpret it?

The debt ratio is used to diagnose the quality and quantity of debt the company has, and also to check to what extent sufficient profit is obtained to support the financial burdens.

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What is the Debt Ratio?

All the debt ratios that can be calculated for different business analysis purposes focus mainly on the short- and long-term liabilities that the company has, all in relation to third parties, such as suppliers, banks and finance companies, the government, among others. 

This analysis also takes into account the liabilities to the shareholders, i.e. the so-called equity, which includes the financing of the company with its own capital, either capital contributed by the shareholders or capital generated through the results of the business activity.

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How to calculate the debt ratio step by step. Debt Ratio Formula

To calculate the basic debt ratio, it is important to perform three steps:

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1 - Calculation of business autonomy

This consists of analyzing the relationship between the company's equity capital and the company's assets, i.e., what percentage of the assets, composed of the company's goods and rights, is financed with equity capital, either capital stock and/or resources generated by the company's profitability.

Autonomy = Net Equity / Assets

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2 - Calculation of business dependence

It consists of analyzing the relationship between the company's obligations or debts to third parties, such as suppliers, banks, the government and other credit institutions, and the company's assets. In other words, it consists of analyzing what proportion of the company's assets and rights are financed with resources borrowed from third parties.

Dependency = Liabilities / Assets

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3 - Calculation of simple or total indebtedness

If analyzed carefully, the relationship of autonomy and dependence have one thing in common, which is the asset. These assets can be financed with own or borrowed capital. In this way, it is possible to generate a simple debt ratio:

Indebtedness = Autonomy / Dependence = Liabilities / (Liabilities + Equity)

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In short, the debt ratio is the relationship between the company's autonomy and dependence, represented by the ratio between the company's total liabilities and the sum of liabilities plus equity. 

When analyzing the company's Balance Sheet, on the left side are the assets, i.e. its goods and rights, and on the right side are the liabilities, i.e. the financing of those goods and rights with outside capital, but also the net worth, i.e. the financing of the assets with own capital, coming from the contributions of the partners or from the company's profitability.

Having made this analysis, it can be seen that it is necessary to maintain a balance between these sources of financing, and not to bet fully on external financing or on own financing. The ideal is a 50/50 balance, depending on various factors, for example: the possibility of access to credit granted by third parties, the cost of borrowed capital, the cost of equity capital, the need to expand installed capacity due to an increase in the company's level of production or sales, the jurisdictions in which it operates, and so on.

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Short-term and long-term debt ratio

Depending on the stakeholders, you may need to know not only the overall indebtedness or total indebtedness, but also the short- and long-term indebtedness situation. The formulas for calculating these are as follows:

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Short-term debt ratio

Short-Term Debt = Current Liabilities / (Liabilities + Equity)

Represents the proportion of debts with third parties to be paid within the next 12 months, in relation to the company's total financing, both its own and from third parties.

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Long-term debt ratio

Long-Term Debt = Non-Current Liabilities / (Liabilities + Shareholders' Equity)

Represents the proportion of debts with third parties to be paid after the next 12 months (medium and long term), in relation to the total financing that the company has, both its own and from third parties.

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How to interpret the Debt Ratio?

For the interpretation of the debt ratio, it is essential to take into account the values detailed below, without forgetting the factors related to the business activity, the situation of the jurisdictions in which the company operates, the cost of equity or debt capital, among others.

Optimal Debt Ratio Levels

The optimum value of this total debt ratio is between 0.4 and 0.6, the ideal being 0.5, i.e., 50% indebtedness with the company's own capital and 50% with capital from third parties.

If the value is greater than 0.6indicates that the volume of debts is excessive and that the company is losing financial autonomy vis-à-vis third parties, in other words, it is decapitalizing and operating with a risky financial structure. 

If the value is less than 0.4is lower, it is possible that the company has excess equity and is losing the opportunity to finance itself with third parties in a convenient manner.

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The importance of the Debt Ratio in Due Diligence

ISO 37001 defines Due Diligence as: "the process for assessing in greater detail the nature and extent of bribery risk, and to assist organizations in making decisions regarding specific transactions, projects, activities, business partners and personnel (broad definition)".

On the other hand, in the customs and habits of business, Due Diligence is a procedure by which it is sought to know deeply the third party of great relevance, through the analysis of the legal and accounting documentation, the procedures carried out by the company, as well as its relations with its stakeholders; all this within the framework of M&A processes, i.e.: corporate transformations, acquisitions, mergers, spin-offs, joint ventures, collaboration agreements and other similar ones.

In this sense, when analyzing accounting information, it is essential to evaluate the company's financial information. In particular, the analysis of indebtedness serves mainly to know whether the company can sustain itself, with adequate autonomy, whether it depends on third parties in a reasonable and balanced manner, or whether it is even on the verge of bankruptcy.

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