In general, it is agreed that companies with high ratios of debt are more dangerous than companies with low ratios of debt, and this article will share with you the definition of debt ratios, the formula for calculating them, and the information revealed when debt ratios are too high or too low。

What is the debt ratio?？

In general, the debt ratio (Debt Ratio) is used to measure the financial risk capacity of an enterprise in terms of operations, and is also an indicator used to determine the financial structure of an enterprise.

In general, the debt ratio is usually demarcated at 50 per cent, preferably no higher than 60 per cent.。Investors will want the lower the debt of the company they invest in, the better, because high debt ratios usually mean that the company pays a higher interest expense and needs to take a higher financial risk.

However, moderate indebtedness can enhance the ability of companies to have sufficient funds to use them to purchase new equipment, add production lines or expand their sites to create more profits.

Simply put, it's not that it's bad to have debt, as long as it's used in moderation, it's also good for the growth of the business and the profitability of shareholders.

Debt Ratio Formula and Calculation

The debt ratio refers to the ratio of a company's total liabilities to all assets and is calculated as follows.

The debt ratio of an enterprise is 50%, which means that the total liabilities of the enterprise account for 50% of the total assets.。For example, a company with total assets of $100 million has total liabilities of $50 million.

While debt ratios can be used to measure the degree of operational risk of a business, some industries (e.g., finance, leasing, and manufacturing) typically operate with higher leverage

Therefore, industrial attributes should also be taken into account when using debt ratios to determine whether a company is suitable for investment

The meaning of the debt ratio.

Debt or shareholder contribution is the two major sources of capital of enterprises, debt financing can play the role of leverage, as long as the use of appropriate, the degree of profit created is higher than the cost of borrowing, the operation of this financial leverage can bring positive effects, improve the return on investment.。

However, if the recession, plummeting turnover and other factors, the enterprise borrowing too much, profit but can not cope with the repayment, due to leverage factors, will not only improve the debt ratio of enterprises, and even increase the financial risk of enterprises.。On the other hand, in the case of low debt ratio, the pressure on the enterprise to repay the debt is less, and the business risk to the enterprise will be lower.。

However, also because the enterprise can not effectively use the resources of external funds, to expand the scale of business, product development, etc., to enhance the profitability of the enterprise, then the enterprise's ability to make money may be reduced.

Gains and losses of high and low debt ratios

high debt ratio

• Advantages: enterprises are optimistic about the future development prospects, through debt can have more capital use, expand business scale, research and development products, play the function of financial leverage, help improve the future profitability of enterprises.

• Risk: Financial leverage increases risk。In the event of a recession or a business that does not develop as expected, it may even face huge pressure to repay its debts and may even be on the verge of bankruptcy.

Low debt ratio

• Advantages: long-term capital stability, low business risk
• Risk: If an enterprise fails to give full play to its financial leverage and is unable to effectively use the resources of external funds to expand its business scale and conduct product research and development to enhance its profitability, its ability to make money may decline as a result.

Additional indicator of excessive debt ratio

Interest Coverage Ratio (Interest Coverage Ratio) is a measure of a company's ability to pay interest.。The larger the value, the better the company's ability to repay its debts and the higher the protection for creditors, calculated as follows.

The result of the interest cover multiple reflects whether the company can repay the interest on the liability from the profit surplus earned.。In general, the interest coverage multiple should be at least five times higher.。If it's less than 2 times, investors should pay more attention.

If it is in a long-term decline, it means that the company's profits will not meet the interest it has to pay on its debt.。In the long run, the company's finances and profitability may be alarming.

Find the debt ratio from the "balance sheet."

The three major statements commonly used in accounting are the income statement, the balance sheet and the cash flow statement, and the balance sheet can be divided into three main parts, namely, "assets," "liabilities" and "shareholders' equity."。

"Liabilities" are subdivided into "current liabilities" and "non-current liabilities," the sum of which is the total amount of liabilities.

Current liabilities are liabilities that will be due and payable within one year, including short-term loans, accounts payable, notes payable, wages payable, dividends payable, and long-term loans due within one year.。Non-current liabilities, which are liabilities with a repayment period of more than one year, such as corporate bonds payable and long-term borrowings

SUMMARY

A company's own debt ratio has its own advantages and disadvantages, and a company with a high debt ratio is not necessarily dangerous.

On the contrary, the moderate use of leverage has a certain positive help for the growth and profitability of enterprises, and if the use of a set "debt ratio < 50%" as a condition for stock selection, may eliminate many growth stage and potential companies.

Through a single financial data, we can not fully grasp the true financial situation of the company。Therefore, it is recommended to refer to other important indicators, such as Interest Coverage Ratio (Interest Coverage Ratio) and Return on Asset (Return on Asset), to further understand the company's solvency.