What is a Debt Ratio?

The debt ratio is a financial ratio that measures the extent of a company’s leverage. The
debt ratio is defined as the ratio of total debt to total assets, expressed as a decimal or
percentage. It can be interpreted as the proportion of a company’s assets that are financed
by debt.

A ratio greater than 1 shows that a considerable portion of debt is funded by assets. In other
words, the company has more liabilities than assets. A high ratio also indicates that a
company may be putting itself at a risk of default on its loans if interest rates were to rise
suddenly. A ratio below 1 translates to the fact that a greater portion of a company's assets is
funded by equity.

The debt ratio is also referred to as the debt-to-assets ratio.

Debt ratio = Total assets

Total debt

What Does the Debt Ratio Tell You?

The higher the debt ratio, the more leveraged a company is, implying greater financial risk.
At the same time, leverage is an important tool that companies use to grow, and many
businesses find sustainable uses for debt.

Debt ratios vary widely across industries, with capital-intensive businesses such as utilities
and pipelines having much higher debt ratios than other industries such as the technology
sector. For example, if a company has total assets of $100 million and total debt of $30
million, its debt ratio is 30% or 0.30. Is this company in a better financial situation than one
with a debt ratio of 40%? The answer depends on the industry.

A debt ratio of 30% may be too high for an industry with volatile cash flows, in which most
businesses take on little debt. A company with a high debt ratio relative to its peers would
probably find it expensive to borrow and could find itself in a crunch if circumstances change.
The fracking industry, for example, experienced tough times beginning in the summer of
2014 due to high levels of debt and plummeting energy prices. Conversely, a debt level of
40% may be easily manageable for a company in a sector such as utilities, where cash flows
are stable and higher debt ratios are the norm.

A debt ratio greater than 1.0 (100%) tells you that a company has more debt than assets.
Meanwhile, a debt ratio less than 100% indicates that a company has more assets than
debt. Used in conjunction with other measures of financial health, the debt ratio can help
investors determine a company's risk level.

Some sources define the debt ratio as total liabilities divided by total assets. This reflects a
certain ambiguity between the terms "debt" and "liabilities" that depends on the
circumstance. The debt-to-equity ratio, for example, is closely related to and more common
than the debt ratio, but uses total liabilities in the numerator. In the case of the debt ratio,
financial data providers calculate it using only long-term and short-term
debt (including current portions of long-term debt), excluding liabilities such as accounts
payable, negative goodwill and "other."

In the consumer lending and mortgages business, two common debt ratios that are used to
assess a borrower’s ability to repay a loan or mortgage are the gross debt service ratio and
the total debt service ratio. The gross debt ratio is defined as the ratio of monthly housing
costs (including mortgage payments, home insurance, and property costs) to monthly
income, while the total debt service ratio is the ratio of monthly housing costs plus other debt
such as car payments and credit card borrowings to monthly income. Acceptable levels of
the total debt service ratio, in percentage terms, range from the mid-30s to the low-40s.

Example
Dave’s Guitar Shop is thinking about building an addition onto the back of its existing
building for more storage. Dave consults with his banker about applying for a new
loan. The bank asks for Dave’s balance to examine his overall debt levels.
The banker discovers that Dave has total assets of $100,000 and total liabilities of
$25,000. Dave’s debt ratio would be calculated like this:

As you can see, Dave only has a debt ratio of .25. In other words, Dave has 4 times
as many assets as he has liabilities. This is a relatively low ratio and implies that
Dave will be able to pay back his loan. Dave shouldn’t have a problem getting
approved for his loan.
Proprietary Ratio

 The proprietary ratio is not amongst the commonly used ratios. Very
few analysts prescribe its usage. This is because in reality it is the
inverse of debt ratio. A higher debt ratio would imply a lower
proprietary ratio and vice versa. Hence this ratio does not reveal any
new information.

Formula

Proprietary Ratio = Total Equity / Debt + Equity

Meaning

 The proprietary ratio is the inverse of debt ratio. It is a part to whole

comparison. The proprietary ratio measures the amount of funds that
investors have contributed towards the capital of a firm in relation to
the total capital that is required by the firm to conduct operations.

Assumptions

 No off Balance Sheet Debt: The presence of off balance sheet debt
may understate the total debt that the firm has. This in turn will
overstate the proprietary ratio. Such accounting can be thought of as
deceptive because it masks the true risk profile of the business.
However, since accountants would be on the right side of the rules, it
is not incorrect for them to do so.

Interpretation

 Depends on Risk Appetite: The ideal value of the proprietary ratio

of the company depends on the risk appetite of the investors. If the
investors agree to take a large amount of risk, then a lower
proprietary ratio is preferred. This is because, more debt means more
leverage means profits and losses both will be magnified. The result
will be highly uncertain payoffs for the investors.

On the other hand, if investors are from the old school of thought,
they would prefer to keep the proprietary ratio high. This ensures less
leverage and more stable returns to the shareholders.

 Depends on Stage of Growth: The ideal value of the proprietary

ratio also depends upon the stage of growth the company is in. Most
companies require a lot of capital when they are at the early stages.
 Issuing too much equity could dilute the earnings potential at this
stage. Therefore a lower proprietary ratio would be desirable at such
a stage allowing the firm to access the capital it wants at a lower
cost.
 Depends on Nature of Business: The firm has to undertake many
risks and balance them out. There are market risks which are
external to the firm and there are capital structure risks that are
internal to the firm. If the external risks are high, the firm must not
undertake aggressive financing because this could lead to a
complete washout of the firm. On the other hand, if the external
environment is stable, the firm can afford to take more risks

Formula:

Some analysts prefer to exclude intangible assets (goodwill etc.) from the
denominator of the above formula. In that case, the formula would be written
as follows:

Significance and interpretation:

The proprietary ratio shows the contribution of stockholders’ in total capital

of the company. A high proprietary ratio, therefore, indicates a strong
financial position of the company and greater security for creditors. A low
ratio indicates that the company is already heavily depending on debts for
its operations. A large portion of debts in the total capital may reduce
creditors interest, increase interest expenses and also the risk of
bankruptcy.

Having a very high proprietary ratio does not always mean that the
company has an ideal capital structure. A company with a very high
proprietary ratio may not be taking full advantage of debt financing for its
operations that is also not a good sign for the stockholders.
Times interest earned (TIE) ratio

Times interest earned (TIE) ratio shows how many times the annual
interest expenses are covered by the net operating income (income before
interest and tax) of the company. It is a long-term solvency ratio that
measures the ability of a company to pay its interest charges as they
become due.Times interest earned ratio is known by various names such
as debt service ratio, fixed charges cover ratio and Interest coverage ratio.
The ratio is expressed in times.

Formula:

Times interest earned ratio is computed by dividing the income before

interest and tax by interest expenses. The formula is given below:

Income before interest and tax (i.e., net operating income) and interest
expense figures are available from the income statement.

Example:

A creditor has extracted the following data from the income statement of
PQR and requests you to compute and explain the times interest earned
ratio for him.

Required: Compute times interest earned (TIE) ratio of PQR company.

Solution:

= (2,570 / 320)

= 8.03 times

The times interest earned ratio of PQR company is 8.03 times. It means
that the interest expenses of the company are 8.03 times covered by its net
operating income (income before interest and tax).

Significance and Interpretation:

Times interest earned ratio is very important from the creditors view point.
A high ratio ensures a periodical interest income for lenders. The
companies with weak ratio may have to face difficulties in raising funds for
their operations.

Generally, a ratio of 2 or higher is considered adequate to protect the

creditors’ interest in the firm. A ratio of less than 1 means the company is
likely to have problems in paying interest on its borrowings.

A very high times interest ratio may be the result of the fact that the
company is unnecessarily careful about its debts and is not taking full
advantage of the debt facilities.
Debt to equity ratio

Debt to equity ratio is a long term solvency ratio that indicates the
soundness of long-term financial policies of a company. It shows the
relation between the portion of assets financed by creditors and the
portion of assets financed by stockholders. As the debt to equity ratio
expresses the relationship between external equity (liabilities) and
internal equity (stockholder’s equity), it is also known as “external-
internal equity ratio”.

Formula:

Debt to equity ratio is calculated by dividing total liabilities by

stockholder’s equity.

The numerator consists of the total of current and long term liabilities
and the denominator consists of the total stockholders’ equity including
preferred stock. Both the elements of the formula are obtained from
company’s balance sheet.

Example:

ABC company has applied for a loan. The lender of the loan requests
you to compute the debt to equity ratio as a part of the long-term
solvency test of the company.

The “Liabilities and Stockholders’ Equity” section of the balance sheet of

ABC company is given below:
Required: Compute debt to equity ratio of ABC company.

Solution:

= 7,250 / 8,500

= 0.85

The debt to equity ratio of ABC company is 0.85 or 0.85 : 1. It means the
liabilities are 85% of stockholders equity or we can say that the creditors
provide 85 cents for each dollar provided by stockholders to finance the
assets.

Significance and interpretation:

A ratio of 1 (or 1 : 1) means that creditors and stockholders equally

contribute to the assets of the business.

A less than 1 ratio indicates that the portion of assets provided by

stockholders is greater than the portion of assets provided by creditors
and a greater than 1 ratio indicates that the portion of assets provided by
creditors is greater than the portion of assets provided by stockholders.

Creditors usually like a low debt to equity ratio because a low ratio (less
than 1) is the indication of greater protection to their money. But
stockholders like to get benefit from the funds provided by the creditors
therefore they would like a high debt to equity ratio.

Debt equity ratio vary from industry to industry. Different norms have
been developed for different industries. A ratio that is ideal for one
industry may be worrisome for another industry. A ratio of 1 : 1 is
normally considered satisfactory for most of the companies.

Example

The Petersen Trading Company has total liabilities of $937,500 and a

debt to equity ratio of 1.25. Calculate total stockholders’ equity of
Petersen Trading Company.

Solution

Debt to equity ratio = Total liabilities/Total stockholder’s equity

or

Total stockholder’s equity = Total liabilities/Debt to equity ratio

= $937,500/1.25

= $750,000
Dividend payout ratio

Dividend payout ratio discloses what portion of the current earnings

the company is paying to its stockholders in the form of dividend and
what portion the company is ploughing back in the business for growth in
future. It is computed by dividing the dividend per share by the earnings
per share (EPS) for a specific period.

Formula:

The formula of dividend payout ratio is given below:

The numerator in the above formula is the dividend per share paid to
common stockholders only. It does not include any dividend paid to
preferred stockholders.

It can also be computed by dividing the total amount of dividend paid on

common stock during a particular period by the total earnings available
to common stockholders for that period.

Example:

The Best Buy Inc. has declared and paid a dividend of $0.66 per share
of common stock. The company does not have any preferred stock
outstanding. The information about common stock and net income is
given below:

Common stock (10,000 shares, $25 par value): $250,000

Net income: $22,000

An investor seeking for continuous dividend income wants to purchase
the share of the Best Buy Inc. For this purpose he requests you to
compute the dividend payout ratio for him from the above information.

Solution:

= $0.66/ $2.2*

= 0.3 or 30%

*Earnings per share of common stock:

$22,000/10,000 shares

Significance and Interpretation:

A low dividend payout ratio means the company is keeping a large

portion of its earnings for growth in future and a high payout ratio means
the company is paying a large portion of its earnings to its common
shareholders.

Whether a payout ratio is good or bad depends on the intention of the

investor. A high payout ratio is usually preferred by those investors who
purchase shares to earn regular dividend income and a low ratio is good
for those who seek appreciation in the value of common stock in future.

Companies with ample reinvestment opportunities and a high rate of

return on assets usually keep a large portion of earnings in the business
and, therefore, have a low dividend payout ratio during the first few
years of establishment. Well established companies usually have a good
consistent dividend payout ratio.