How to calculate the Debt Ratio in the company? → Practical examples

The decision to launch a business requires the evaluation of aspects such as its business model, the equity capital available for its financing and whether it will be necessary to resort to external sources of financing. The relationship between these last two aspects is known as the debt ratio.

This financial indicator, which relates the amount of equity to the amount of external funds or financial leverage required, shows the company's level of indebtedness and allows foreseeing actions to face eventual financial difficulties.

In this opportunity, learn how to calculate your company's debt ratio and how to interpret the values you obtain. Formulas and practical exercises throughout the article.

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What is the debt ratio and what does it show?

In the business world, we often talk about the financial structure of a company or its working capital. This is given by:

• Its net worth (assets): i.e. equity;
• external financing (liabilities), i.e., borrowed funds or the sum of short-term and long-term debt.

With respect to the above, the company's debt ratio or total leverage is an indicator that shows the proportion of debt that the company has with respect to its own financing capacity.

Additionally, there is another type of useful information that can be obtained from the debt ratio and that contribute to a better management of the business:

• Determine the financial health of the company, finding its break-even point.
• Identify the sources of external financing that are part of the company's financial structure.
• To know the company's debt in relation to its equity.
• To measure the financial risk that the company may face.

How is the debt ratio calculated?

To calculate a company's indebtedness ratio, by directly comparing debt with equity, you must start by using the data appearing in the balance sheet on the day you wish to perform the analysis.

The values corresponding to total liabilities (sum of current liabilities and fixed liabilities) and shareholders' equity are consulted in the balance sheet.

Debt ratio: formula

In general, the debt ratio is calculated using the following formula:

Where,

• Liabilities → obligations and debts with third parties (short and long term);
• Equity → share capital, reserves or undistributed profits of previous years and results of the current year.

💡 Calculating the debt ratio as a percentage is also possible: just take the result you obtained and multiply it by 100.

What values of the debt ratio are acceptable?

As with many other financial indicators, the values determined for them are in many cases only indicative. This is because each sector of the economy behaves differently and is therefore subject to different values and returns.

Furthermore, the concept of debt in the business world does not necessarily have to be negative, especially if the rate of return is favorable. There are few companies that do not need to resort to external funds to start developing.

Therefore, we could speak of a recommended range within which a company's debt ratio should fall, but not of an ideal debt ratio:

This range is between 40 and 60 percent or, in other words, less than 1:

However, in general, it is clear that a company's indebtedness should not exceed its capacity to meet its obligations to third parties such as suppliers, creditors or banks.

How to interpret the debt ratio?

From the definition of the concept and its calculation formula, you already have a clear idea of what this financial ratio means. But how to understand and analyze its results?

This ratio indicates the percentage that the total amount of the company's debts represents in relation to its own resources. This means that what it is indicating is how many euros of external financing the company has for each euro of its own financing.

The higher the company's debt volume, the greater the difficulties it will have to face for the take-off and growth of the business, since its payment capacity is reduced.

Having said the above and according to the acceptable values we reviewed previously, we could consider that:

• RE < 0.40 → the company still has resources that can be leveraged.
• ER > 0.60 → the company has a high level of indebtedness.

Debt ratio: practical examples

Debt ratio: exercise solutions

✍ Let's look at an example of the calculation of the debt ratio for a company in the tertiary sector, whose Balance Sheet shows the following information:

• Current and non-current assets = Total assets = 15 000 + 20 000 = 35 000€.
• Current and non-current liabilities = Total liabilities = 1 000 + 8 000 = 9 000€.
• Shareholders' equity = 21 000

👇

Debt Ratio = Liabilities / Equity

Debt ratio = 9,000 / 21,000

Debt ratio = 0.42 = 42 %.

The above result can be interpreted as follows: for every 0.42 euros of external financing, the company has one (1) euro of its own financing. The above value indicates a certain degree of financial independence of the company with respect to its debts to third parties.

✍ In the opposite case, if the same company were to present the following figures:

• Total assets = 35 000€.
• Total liabilities = 12 000€.
• Equity = 18 000€.

👇

Debt ratio = Liabilities / Shareholders' equity

Debt ratio = 12,000 / 18,000

Debt ratio = 0.66 = 66%.

Even if the value of the debt ratio is slightly above the recommended range for a service company, its debt repayment capacity (solvency or liquidity) is not necessarily at risk.

Short-term and long-term debt ratio

Since debts can be classified according to their term to maturity as follows:

• Short-term debts (current liabilities): payment term of less than one year,
• Long-term debts (fixed liabilities): payment term of more than one year,

there is also the possibility of calculating the debt ratio in a specific way, based on the following formulas:

• Short-term indebtedness ratio:

• Long-term debt ratio:

Now that you have all the elements to calculate your debt ratio, don't get into debt with your business and ensure its sustainability over time!

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Debt: an advantageous solution for the company or a double-edged sword?

It is common that when a company debuts on the market, it must resort to external financing to start developing its activity.

In fact, indebtedness can be assumed as a strategic business financing solution, as long as the company presents favorable projections and has, in general, a good economic performance. In other words, its balance sheet is positive.

However, the financial risks involved in this model should not be underestimated. It is essential that a real analysis of the company's economic situation be made at all times, taking care that the company does not reach a point of no return, in which its debt becomes unmanageable.