BREAKING DOWN 'Debt Ratio'

The higher this ratio, the more leveraged the 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 like technology. 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, brought on by 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 of greater than 100% tells you that a company has more debt than assets. Meanwhile, a debt ratio of 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." The debt ratio is often called the "debt-to-assets ratio."

Let's look at a few examples from different industries to contextualize the debt ratio. Starbucks Corp. (SBUX) listed $549,800,000 in short-term and current portion of long-term debt on its balance sheet for the quarter ending June 28, 2015, and $2,347,400,000 in long-term debt. The company's total assets were $12,868,800,000. This gives us a debt ratio of (549,800,000 + 2,347,400,000) ÷ 12,868,800,000 = 0.2251, or 22.51%.

To assess whether this is high, we should consider the capital expenditures that go into opening a Starbucks: leasing commercial space, renovating it to fit a certain layout, and purchasing expensive specialty equipment, much of which is used infrequently. The company must also hire and train employees in an industry with exceptionally high employee turnover, adhere to food safety regulations, etc. for 21,000 locations, in 65

countries. Perhaps 23% isn't so bad after all, and indeed Morningstar gives the industry average as 40%. 

The result is that Starbucks has an easy time borrowing money; creditors trust that it is in a solid financial position and can be expected to pay them back in full. Fixed-rate, non-callable Starbucks bonds with a maturity date in 2045 have a coupon rate of 4.3%.

What about a technology company? For the quarter ending June 30, 2015, Facebook Inc. (FB) reported its short-term and current portion of long-term debt as $221,000,000; its long-term debt was $110,000,000; its total assets were $44,130,000,000. (221,000,000 + 110,000,000) ÷ 44,130,000,000 = 0.0075, or 0.75%. Facebook does not borrow on the corporate bond market. It has an easy enough time raising capital through stock.

Finally, let's look at a basic materials company, the St. Louis-based miner Arch Coal Inc. (ACI). For the quarter ending June 30, 2015, the company posted short-term and current portions of long-term debt of $31,763,000, long-term debt of $5,114,581,000 and total assets of $8,036,355,000. Coal mining is extremely capital-intensive, so the industry is forgiving of leverage: the average debt ratio is 47%. Even in this cohort, though, Arch Coal is heavily indebted; its debt ratio is 64%. Predictably, this makes borrowing expensive. Arch Coal's fixed, non-callable bonds with a maturity date in 2023 carry a hefty coupon rate of 12.0%

In the consumer lending and mortgages business, two common debt ratios 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.

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