The index or debt ratio is a solvency ratio that measures how much external debt a company uses to finance its assets in relation to its net worth.
We understand by external financing debts contracted with third parties, such as banks or creditors of another nature.
It reflects the financial health of the company, indicating the existence or absence of financial imbalances, derived from the excess of external financing.
Debt ratio formula
When analyzing a company, this is a key ratio, as it reflects the company's financing policy. Answer questions like the following:
- To what extent does the company depend on banks to carry out its activity?
- Is it preferable to carry out a capital increase or to borrow the company?
- In what proportion?
The debt ratio formula is as follows:
The ratio relates the two sources of financing of a company, own resources and external resources. It reflects the way in which both shareholders and creditors finance the company:
- External financing: These are bonds and obligations with third parties. That is, loans and credits with financial institutions, creditors, suppliers, etc. They can be short and / or long term. Short debts can be used to cover current expenses while long debts can be used to finance investments. These companies with which the debts are contracted lack participation in the shareholding and, therefore, they are not owners or partners of the company.
- Own funds or equity: Constituted by contributions of capital stock, reserves, results of previous years, grants and donations and other items such as adjustments for changes in value. In other words, it is the company's own source of financing.
The value of a business is not measured only by what it has, but by its financial structure: the relationship between what it has and what it owes.
External financing does not increase the value of the company until the debt is paid, since the asset will not be owned by the company until then. In contrast, increasing equity does increase the value of the business. In addition, increasing external financing means increasing the risk of interest rates and insolvency in the face of adverse economic conditions. They are fixed obligations.
Therefore, analyzing the relationship between debt and equity is essential to know the real situation of the company and confirm its ability to repay the debt.
Short-term and long-term debt formulas
We can also study the short-term and long-term debt ratio, substituting the numerator for the amount of current liabilities (debts with maturities of less than one year) and non-current liabilities (greater than one year), respectively:
The result will be negative only when the company is in technical bankruptcy. That is, when its accumulated losses are higher than its own funds and, therefore, the net worth (denominator) is negative.
Debt can be beneficial or detrimental to the company, depending on its conditions, interest rate and the profitability obtained. It will be beneficial when the investment obtains a return greater than the interest rate of the debt contracted, and vice versa.
Interpretation of the debt ratio
The interpretation of the debt index can be summarized as follows:
- Ratio <1 → A ratio less than 1 indicates that the company owes less than 1 euro for each euro of the shareholder. For example, a ratio of 0.5 implies that for every euro of debt, the shareholder puts 0.5.
- Ratio = 1 → A ratio equal to 1 indicates that the company owes exactly 1 euro for every euro of the shareholder. For example, a ratio of 1 means that the investment is financed in equal parts with external debt and shareholder contributions.
- Ratio> 1 → A ratio greater than 1 indicates that the company owes more than 1 euro for each euro of the shareholder. Finally, if the ratio is 1.2, it indicates that the company owes 1.2 euros for each euro of the shareholder.
High values (greater than 1) can be a symptom of financial imbalances, since the value of the debts exceeds the value of the company. They indicate excess indebtedness. On the other hand, low results can mean idle resources, opportunity costs, and competitiveness problems.
Healthy values are between 0.4 and 0.6. However, to value the ratio, it is necessary to attend to the sector and the characteristics of each company, and relate it to that of its peers or comparable. The average ratio of the industrial sector, construction or energy, whose projects involve large amounts of initial investment and large infrastructure to function, is not the same as the service sector, commerce or agriculture, which can start their activity with more financial structures. balanced.
Control and indebtedness
However, it must also be borne in mind that with capital increases the ownership of the business is divided into more hands. While a loan implies maintaining control of the company.
The appropriate and consistent thing is to guarantee a healthy balance, in accordance with the peculiarities of the company.