Moving on to leverage ratios, Axel Tracy introduces the debt ratio to readers of “Ratio Analysis Fundamentals: How 17 Financial Ratios Can Allow You to Analyse Any Business on the Planet.”
Leverage is the use of borrowed money to increase returns on an investment. For example, if we can borrow at 5% and invest that money in stocks earning 10%, then we have doubled our earnings power. We have levered our existing investment.
Of course, leverage can also backfire and magnify our losses rather than enhance them. So we need to analyze the use of debt carefully, and one of the metrics we use for that purpose is the debt ratio. Tracy wrote, “It is both a risk ratio in regards to solvency as well as strategy ratio as it can also be viewed as the level of assets within a business that are financed by debt.” He added, “Simply put, it measures the level of liabilities in relation to assets and is expressed as a percentage.”
Because it is listed as a percentage and not as an absolute figure, it can be compared across companies. It also indicates what would be left for the owners if all assets were sold and all debts were repaid. On the strategic side, the debt ratio tells us what percentages of assets were financed by debt and by equity.
The formula is:
"Debt Ratio = Liabilities / Assets"
Data for both liabilities and assets come from the balance sheet.
GuruFocus does not provide a debt ratio reading, but provides a similar metric, the debt-to-equity ratio (which we will discuss in a future article). While the debt ratio is defined as liabilities divided by assets, the debt-to-equity ratio is defined as liabilities divided by shareholder’s equity. The debt-to-equity ratio at GuruFocus is found in the financial strength section of the summary page; in this example, it’s for 3M MMM:
Returning to the debt ratio, Tracy reminded us it is expressed as a percentage, and a ratio of 65%, for example, means 65% of the company’s assets were financed by debt. It also means that the company owes 65 cents of debt for every $1 in assets.
The debt ratio also measures risk; if the level of debt goes up or goes down, the level of risk moves with it. More debt = more risk. Generally, a lower debt ratio is considered better because the business is safer and the odds of it going broke are reduced. When there are more assets than debt, there is a solid case that the company’s financial situation is strong.
Two factors affect the debt ratio: Lower or higher debt and lower or higher asset values. There are several ways in which a debt can be lowered; one method is to increase sales and use a portion of the revenue or earnings to accelerate debt repayments. Asset values might be increased by means such as using a portion of higher sales or profits to purchase new and better equipment. Of course, such a proposition only makes sense when the cost of the debt is no higher than the cost of the assets.
Tracy also makes the point that we should be wary of a debt ratio of more than 100%. He wrote, “On the negative side, if the result is above 100% then, in theory, the business could not pay off all its debts even if it sold every one of its assets. This is a negative for both creditors and the business itself.”
One important criticism of the debt ratio is that it is too broad a measure. For example, it does not deal with smaller segments of assets and liabilities such as current versus non-current assets or liabilities. The debt ratio cannot take into account that a company may have mostly long-term debts and is, therefore, not at risk.
Another criticism is that the debt ratio is based on book value, which may be different than fair value. Tracy compares this with homeowners who want to sell their homes quickly and are forced to lower the price below its fair value to get an immediate sale. He added, in an understatement, “This is why using the Debt Ratio to tell us how much would be left over for the owners or tell us how easily a company could pay off all its debts, may not be 100% accurate.
Conclusion
The debt ratio, as described by Tracy in “Ratio Analysis Fundamentals How 17 Financial Ratios Can Allow You to Analyse Any Business on the Planet,” is a useful measure, but one that should be used with caution.
It tells investors a story, but not the whole story. The basic story is the relationship between a company’s debts and its assets, of how much leverage the company is using to speed up its revenue and earnings.
The “whole” story, the broader perspective, is that debt is determined by company policy, and all company policies are a reflection of a unique set of business objectives, conditions and practices.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
- Ratio Analysis: The Acid-Test Ratio
- Ratio Analysis: The Current Ratio
- Ratio Analysis: Return on Equity
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