Debt ratio: an essential metric

The finance and accounting department is one of the most important in any company. It is up to him to ensure that the financial health of the organization is correct. In other words, there is an adequate correlation between income and expenses that allow benefits to be obtained. In order to make an assessment of the financial situation, the debt ratio is one of the metrics that we cannot ignore.

What is the debt ratio?

money debt

It is a metric that allows us to know the relationship between the company’s own funds and the debts that it has to pay in the short and long term. All this with the objective of knowing if the company is really in a good economic position that allows it to return the requested money to external sources or if on the contrary it has or will have problems to settle its debts.

Knowing this data is essential to better understand the moment the company is going through. And it also serves to develop other analysis tools such as financial study.

How is it calculated?

The formula is very simple:

Debt ratio = total debt (including current and non-current liabilities) / equity (or equity)

We get the result as much for one. If we prefer to obtain a percentage as a result, all we have to do is multiply the figure obtained by 100.

Interpretation of the debt ratio

money debt

Once the calculation is done, you have to know how to interpret the data. What the result tells us is what is the percentage or weight of debts with respect to the company’s own resources. In other words, how many euros we owe for each euro of equity. As is often the case with financial ratios, there is no result that we can qualify as optimal, it all depends on the conditions of each company.

Logically, if the debt ratio exceeds 60% we are facing a worrying situation, since there is more debt than equity. However, a low ratio is not always good news. A company that has an indebtedness level of 30% or knows how to manage its resources very well (which is very good) or is adopting a too protectionist strategy and is not making the investments it needs, which is nothing positive. In general, it is estimated that if the debt ratio is between 0.4 and 0.6, it has an adequate level. Then it will be necessary to examine more carefully the finances of the company, its conditions and the sector in which it operates to know if that figure is optimal or not.

 

Can there be a negative debt ratio?

money debt

That’s right, but it’s a complicated thing to see. In order for the result of the division to be a negative number, it is necessary that either the liability or the net equity be negative. It is complicated that the liability is negative. This means that the company not only has no debts but also its creditors who owe money to it.

If what is negative is equity, we are in a situation where the company does not have its own resources with which to finance part of its economic needs, it depends entirely on external financing. That is, in this case the debt ratio will be very high and certainly not optimal.
Are you interested in learning more about financial and economic ratios and their importance for companies? Then our Master in Financial Management is for you.