- A company’s debt ratio is measured by dividing its total debt by its total assets.
- A higher ratio can be a bad sign as the company may have taken on too much debt and be unable to pay it off.
- Debt ratios vary widely by industry, so you should compare it to industry averages to get a better picture of whether a particular company has too much or too little debt.
You know from a personal standpoint that if you get in over your head with debt and cannot pay it off, you could go bankrupt. The same principle applies to companies.
The debt ratio, or debt-to-asset ratio, is one way of measuring the financial health of a company. You take the company’s total debt and divide it by its total assets. In essence, the higher the debt ratio, the riskier the company as it may have taken on more debt that it can reliably and realistically pay off.
When you're trying to figure out which companies to invest in, you want to make sure you're accurately judging how risky they are, and the amount of debt they have plays a big role in that.
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What is a debt ratio?
The formula for a debt ratio is simple:
Debt ratio = Total debt / Total assets
In other words, it's a measure of how much of the company's assets (which can be physical like a factory or vehicle, or intangible like a brand or reputation) are financed by debt (think, loans, accounts payable).
If a company's debt ratio is equal to 1, it means that it has the same amount of debt as its assets. If a company's debt ratio is less than 1, it means it has more assets than debt. If it’s higher than one, it’s not looking good.
Where do you find the debt ratio?
Publicly-traded companies–those that are listed on stock markets like Nasdaq–have to publish their financial statements, according to the U.S. Securities and Exchange Commission.
You can find them on their investor relations site. Let's take Columbia Sportswear. In their case, you can find the financial statements under the “Financial Info” tab, where you’ll see the company’s 10-Q form, which is their quarterly earnings report and contains their balance sheet, including debt and asset information.
You can also find the same financial information on websites like Yahoo! Finance or through your favorite search engine.
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Once you find the balance sheet, find the numbers for total debt. You may need to add together "short-term debt" and "long-term debt" in order to get this number. Then, divide this by the total assets.
For example, according to the balance sheet for the Columbia outdoor clothing company, it had $385,095 in total debt, and $3,067,128 in total assets for the last quarter of 2021. That made for a debt ratio of 0.13, or 13%—meaning, the company has relatively low debt levels relative to how much the company is worth.
How can you tell whether a particular debt ratio is good or bad?
Instinctively, you might think that having as low of a debt ratio as possible would be good, and a high one would be bad. But there's a bit more nuance to it than that, says Anessa Custovic, the chief investment officer at Cardinal Retirement Planning, Inc.
"I would only look at it in context,” Custovic says. “If you are looking at a company as a potential investment, make sure you check and see what industry averages of the debt ratio are—is this firm more leveraged than the average? Is it less leveraged?"
Some industries simply require more debt in order to operate, and that's just normal. A food service company needs equipment, real estate, supplies and a lot of employees, for example, while a tech company might only need a limited number of servers and a smaller workforce to operate.
You can find industry averages to compare a particular company to in many places, including Ready Ratios.
That said, do be wary of very high debt ratios
Having a higher-than-average debt ratio is something to watch out for because it means the company could be over-leveraged — i.e., it has too much debt.
If a company has a higher-than-average debt ratio, it means it could struggle to pay its bills or even go bankrupt. It also means it could have a harder time taking on more debt to help finance growth, which investors watch keenly.
AMC Entertainment, the world’s largest movie theater chain, is one example of a company with a high debt to asset ratio, currently just above 1. The company, of course, got hit hard by the Covid pandemic, and had to keep the theater doors shut for months. It’s in that position for an understandable reason, but there’s no guarantee it’ll be able to get out swiftly and without damage.
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Also be on the lookout for very low debt ratios
Another potential hazard is if a company has too low of a debt-to-asset ratio compared with its peers.
"A very low debt ratio could imply the company is not growing as fast as it could be if it took on additional debt to finance expansions," says Custovic. And, as mentioned above, growth is the end-all, be-all for many investors
Proceed with caution
Debt to asset ratios aren’t useful metrics in all cases. Some of the biggest companies in the world have low debt ratios, including Apple and Google. In those cases, they are swimming in cash and have no reason to go deep into debt.
"But they are both extremely coveted stocks and investors are not looking to dump them anytime soon," says Custovic. Investors look at other metrics in these cases.
Like other big decisions, you shouldn't make an investing decision based on a single metric. It doesn't tell you the full picture. You can also use metrics like earnings per share (a measure of profitability that shows how much the company is making per outstanding share of common stock) or operating margins (a measure of how much profit a company makes after paying for production costs) .
"All of these combined with the debt ratio provide a more complete picture of the company’s financial health," says Custovic.