Debt Ratio – Formula, Meaning, Assumptions and Interpretation

The debt ratio is the second most important ratio when it comes to gauging the capital structure and solvency an organization. This article provides an in-depth look.

Formula

Debt Ratio = Total Debt / Total Capital

The debt ratio is a part to whole comparison as compared to debt to equity ratio which is a part to part comparison.

Another major difference between the debt to equity ratio and the debt ratio is the fact that debt to equity ratio uses only long term debt while debt ratio uses total debt.

Total debt means current liabilities are also included in the calculation and so is the debt due for maturity in the coming year.

Meaning

The debt ratio tells the investment community the amount of funds that have been contributed by creditors instead of the shareholders. The creditors of the firm accept a lower rate of return for fixed secure payments whereas shareholders prefer the uncertainty and risk for higher payments.

If too much capital of the company is being contributed by the creditors it means that debt holders are taking on all of the risk and they start demanding higher rates of interest to compensate them for the same.

Assumptions

Like debt to equity ratio, the debt ratio assumes the absence of off balance sheet financing. However given the fact that companies now indulge in structured finance and derivatives to a very large extent this assumption seems unreasonable.

Interpretation

The debt ratio of a company is highly subjective. There is no such thing as an ideal debt ratio. Neither are industry wide comparisons very helpful because the capital structure of a company is an internal decision. Here is how to interpret the debt ratio of a company.

• Certainty: Debt is not harmful as long as the revenues in question are fairly certain. Debt becomes a problem when the revenues of the company are wildly fluctuating. This is when there arise situations when the company may not have enough cash on hand to meet its interest obligations.

  Hence while looking at the debt ratio analysts usually also look at the revenues with regards to how certain they are to gauge the riskiness. Whether these revenues are converted to cash fast enough to meet the interest obligations is also under consideration.

• Tax Shield Advantages: Debt is a tax deductible expense. Hence the amount of interest paid reduces the tax bill of the company. One of the advantages of having a higher debt ratio is that you have to pay less to the government in taxes.