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CH 20] Calculating Business 20-9

Debt Ratio. This ratio measures the financial leverage of a company by measuring a
firm’s total liabilities in relation to its total assets. The debt ratio expresses a firm’s ability to
pay off its liabilities with its assets. It calculates the value of assets that must be sold to pay
off liabilities. Companies with higher levels of liabilities compared with assets are considered
highly leveraged greater debt and more risky for lenders.
The debt ratio shows the overall debt burden of the firm. It is a balance sheet ratio and is
calculated by dividing total liabilities by total assets. The equation is:
Total Liabilities
Debt Ratio = ————————
Total Assets

The debt ratio is shown in decimal format because it calculates total liabilities as a ratio of
total assets. For solvency ratios, a lower ratio is more favorable than a higher ratio. A lower
debt ratio usually implies a more stable business with the potential of longevity because a 20
company with lower ratio also has lower overall debt. Each industry has its own benchmarks
for debt, but 0.5 is reasonable ratio as the firm is considered to be less risky. A ratio of 0.5
means that the company has twice as many assets than liabilities; liabilities are (0.5/1 x
100% =) 50% of the total assets. Simply stated: only 50% of the assets are encumbered.
When the ratio approaches a value of 1, this indicates that liabilities approach 100%
encumbrance. Presuming that the debt ratio is 1, the firm would have to sell 100% of its
assets to pay off its liabilities to become encumbrance free. Of course, the firm would also be
out of business.

Example A: The Dunbar Company wants to expand its current building to include more
storage. Consulting with the bank, Dunbar provides the banker with a balance
Sheet, Figure 20.1. The total assets are $227,400 and the total liabilities are
$72,820. What is the Dunbar Company’s debt ratio?

Solution algorithm:
Total Liabilities
Debt Ratio = ——————— Note: 0.16 x 100 : 1 x 100 =
Total Assets
16 : 100
$72,820
Debt Ratio = —————
$445,800

= 0.16 = 0.16 : 1 = 16 : 100

A ratio of 0.16:1 indicates that the Dunbar Company has (1.00 ÷ 0.16 =) 6.25 times as
many assets as it has liabilities (debt). This is a relatively low ratio and implies its ability to
pay back a loan.

Equity Ratio. As a solvency ratio, the equity ratio measure that portion of assets
financed by the owner’s investments by comparing the total equity in the company to the
total assets. This measures the investment leverage. The Equity Ratio equation is:
Total Equity
Equity Ratio = ——————
Total Assets

The equity ratio highlights two important financial concepts of a solvent business:
(a) How much of the firm’s assets are owned outright, and
(b) It inversely shows how leveraged the company is with debt.

This ratio shows how much, after all liabilities are met, the value the firm retains from
the remaining assets; and conversely, the amount of assets financed by debt.
Generally speaking higher equity ratios are favorable for companies. Higher investment
levels by shareholders shows potential shareholders that the company is worth investing in
because so many investors have already invested in the company by purchasing shares of
ownership. A higher ratio also demonstrates to potential creditors that the company is more
sustainable and should be less risky for future loans.
Equity financing, selling shares of ownership, is less expensive than debt financing
because the interest payments are eliminated and the owners share in a firm’s profits.
Companies with higher equity ratios should have less financing and debt service costs such
as interest payments on borrowed dollars, than companies with lower ratios.

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