It is important to calculate a company debt ratio as it is a key component of the learn trading and investment course.
To calculate the company debt ratio we use the following formulae:
Debt Ratio = Total Liabilities / Total Assets x 100 (to get it in %).
Let’s consider an example, below are some figures extracted from XYZ plc’s most recent balance sheet.
Calculate the company’s debt ratio:
XYZ’s company debt ratio = 3680 ÷ 6750 = 54.5%
This would appear quite high as 54.5% of the company’s total assets are financed by debt. But lets look to see if the company can afford to make the interest payments using the following formula:
Interest cover = (Income before tax and interest paid) ÷ Interest paid
Calculate the company’s interest cover:
(685 + 375 + 15.5) ÷ 15.5 = 69.3
This means that the company’s earnings exceed the interest payments by 69.3 times. So although the debt is 54.5% the company can easily afford the interest payments.
A company debt ratio of greater than 100% indicates that a company has more debt than assets. Mean-while, a debt ratio of less than 100% indicates that a company has more assets than debt.
As investors we should err on the side of caution and look for a company debt ratio which is below 35%. If a company’s debt levels exceed that, it often proves difficult for the directors to be able to borrow more at a certain price in order to expand the company even more, and without expansion into new markets, which is normally done by debt, corporate growth will eventually slow down and then the stock price will be affected.
Companies with lower debt often have better prospects for future expansion because they can still raise their debt, but remember we still want companies to have a certain level of debt.
Below is a video on company debt ratio: