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Lesson 8: Solvency Ratios, Debt Ratio

Debt Ratio, fundamental analysis

Debt Ratio, fundamental analysisIn the previous articles, we have seen the Liquidity Ratios (Current Ratio, Quick Ratio, Cash Ratio). Let's see now, the Solvency Ratios which give an indication of a company’s long-term solvency. The first of them I am going to analyse is the Debt Ratio.

Debt Ratio, also known as debt to asset ratio or debt to capital ratio, is an index that measures a company’s total liabilities as a percentage of its total assets. The debt ratio shows company's ability to handle its obligations, paying off its liabilities with its assets. In other words, this shows how many assets the company must sell to pay off all of its liabilities.

This ratio measures the financial leverage of a company. Companies with higher levels of liabilities compared with assets are considered highly leveraged and more risky for creditors. It helps investors and creditors analysis the overall debt burden on the company as well as its ability to pay off the debt in future, uncertain economic times,

Debt Ratio is calculated as follows: :

Debt Ratio, Solvency Ratios, Fundamental Analysis

 

Debt Ratio is a solvency ratio, and as with many solvency ratios, a lower ratio is more favourable than a higher one. The debt ratio is a fundamental solvency ratio because creditors are always concerned about being repaid. When companies borrow more money, their ratio increases creditors will no longer loan them money. Companies with higher debt ratios are better off looking to equity financing to grow their operations.

Although it is not reasonable to identify an equal target value for each company, as the degree of dependence by third parties is also dependent on profitability and development rate, we, in any case, identify those risk-weighted values which, if passed, could be for the company cause of a crisis:

  • Debt Ratio < 0,50 –> Positive situation. Most of the company's assets are financed through equity.
  • Debt Ratio between 0.50 and 1 –> Marginal situation. It allows the use of leverage (the use of third-party capital to support the growth of the company).
  • Debt Ratio > 1 –> Negative situation. A considerable proportion of assets are being funded with debt, and a company may be putting itself at risk of not being able to pay back its debts, which is a particular problem when the business is located in a highly cyclical industry where cash flows can suddenly decline.

 

Example

A company has total liabilities in the amount of $ 80,000 and total assets in the amount of $ 130,000. This gives a debt ratio of 0.62. This means that 62% of the company’s assets are financed by the creditors and debt, and therefore 39% is financed by the owners (equity). A higher percentage indicates more leverage and more risk. 

Debt Ratio, Solvency Ratios, Fundamental Analysis

 

The amount of leverage, that is debt that is right for the company varies based on the industry in which the company operates and the maturity of the company as well as other factors. What is optimal for one company might not be right for another. However, lower debt and higher equity levels generally indicate a lower risk for the investors.

The debt ratio can be compared to the industry average, to other companies, or trended over time to see how a company is doing managing its debt.

In the next article, after the Christmas season, we will see the Debt to Equity Ratio.

 

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