Two millennials walk into a bar.
Both of them have $30,000 in student loan debt. One orders an IPA for $7, and the other orders an Aperol spritz for $12. Which one has a lower debt ratio?
The answer is the one that drove them to the bar. Why? Their car is an asset.
Still don’t get it? You will after reading about debt ratio, an easy calculation used to illustrate financial viability.
What is debt ratio?
Debt ratio, or debt to asset ratio, is a leverage ratio that measures a company’s or individual’s debt against its assets. It is expressed as total debt divided by total assets. It’s a useful ratio for investors to use because it helps them determine the default risk of a company.
In other words, how much is a company leveraging, or how much of its financing is coming from debt capital? Once we know this ratio, we can use it to determine how likely a company is to become unable to pay off its debts.
Debt ratio formula
Debt ratio = Total debt/Total assets
The difference between debt ratio and debt to equity ratio is that when calculating the latter, you divide total liabilities by total shareholder equity. Total liabilities include not just company debt, but accounts payable too. That number is then divided by shareholder equity, which refers to total company assets minus total liabilities, determining a company’s debt to equity ratio.
|Tip: Sometimes accounts payable is included in total debt when calculating debt ratio, but it is typically considered a short-term expense as opposed to part of a company’s outstanding debt. When calculating the debt ratio of a company, it’s up to you to decide whether or not to include it.
What is a good debt ratio?
Generally, a lower debt ratio is better. The closer the ratio gets to 1, the more debt a company has in relation to its assets. If it is higher than 0.5, that means that more than half of a company’s working capital (the money it uses for operations and growth) is coming from debt. A rule of thumb for companies is to keep their debt ratios under 0.6, but a good debt ratio varies by industry.
Investors, financial analysts, and shareholders must compare a company’s debt ratio to the average debt ratio in its industry or the debt ratios of its competitors if they want to effectively use the information to help them invest, trade, lend, or advise. Financial research software can be used to easily compare debt ratios and other financial ratios across industries.
|Tip: Industries with steady cash flows usually have lower debt ratios, and industries with volatile cash flows have higher average debt ratios.
How to calculate debt ratio
To calculate the debt ratio of a company, you’ll need information about its debt and assets. This can be found on the company’s balance sheet. You can access the balance sheets of publicly traded companies on websites like Yahoo Finance or Nasdaq. Some companies post them on their own websites as well.
Let’s walk through a couple of examples of how to calculate a debt ratio using data from Heineken's and Campari Group’s 2018 filings. Since both are European companies, the data on their balance sheets is measured in Euros. No need to convert into U.S. Dollars—the debt ratios will be the same.
Campari Group (DVDCY)
Total assets: €4,582.5 million
Total liabilities: €2419.7 million
Debt ratio = 2419.7/4582.5 = 0.53
At 0.53, Campari Group is doing ok. About half of the company’s capital is coming from debt, and for the wine, beer, and spirit industry, that’s not bad.
Total assets: €41,956 million
Total liabilities: €27,598 million
Debt ratio = 27,598/41,956 = 0.66
At 0.66, Heineken's debt ratio is higher than Campari’s, higher than the industry average, and higher than what would be acceptable in any industry. A high ratio like this makes it harder for the company to find additional debt financing. It also makes them less appealing to investors.
|Related: Debt isn't always a bad thing, especially if you prepare for it. Learn how creating a sinking fund helps corporations get ahead of their debts.
It’s all fun and games...
...until somebody defaults on a loan. All jokes aside, debt ratio is a helpful way to determine how much of a company’s capital structure is made up of debt. Simply dividing total debt by total assets can tell you a lot about financial stability.