Debt ratios: what they are and how to apply them in your company

Most companies, besides their own capital, rely on third-party capital to run their business. Even so, you need to track the evolution of debt through debt ratios to avoid problems down the road.

Using third-party capital to expand production or even open new branches is not all bad, but when debt reaches a certain limit, the company struggles to meet its commitments.

That even affects executives’ well-being. According to a recent survey by Serasaopens in a new tab (in Portuguese), 88% of Brazilians have felt ashamed of owing money, and 85% said they have trouble sleeping because of their debt.

So to avoid this problem, a company’s finance department needs to consider how far leverage is working in its favor, and how far it weighs on the profit statements.

For that, the best path is to constantly track debt ratios. And if you are looking to get to know these ratios better, you are in the right place. Stay with us for three more minutes.

Siteware prepared a 100% free debt ratio tracking spreadsheet for you. Download it now and make the most of it:

What are debt ratios?

Debt ratios are indexes that show, in numbers, an organization’s level of debt, indicating whether that debt is at a safe or a risky level.

As we mentioned, it is common for companies to borrow money from third parties to run their business, such as:

• banks and credit institutions;
• suppliers;
• investorsopens in a new tab (in Portuguese).

Banks and investors who lend money to an institution want a return on that loan in exchange. Suppliers, on the other hand, lend capital through the payment term they grant.

To track debt ratios and others in the best way, it is important to have systems for analyzing indicators and results. See which are the 9 best →

In this case there is no interest charge, and the term granted is a way to close the sale and build a longer-lasting business partnership. Here there is less impact on the company’s costs.opens in a new tab

What are debt ratios for?

Debt ratios show a company’s owners and managers whether the debt to third parties is at a good level or moving into riskier territory.

These ratios are what let the organization decide between expanding production or even cutting costs to avoid future problems with suppliers and even with banks and investors.

A high level of debt can lead the institution to insolvency, raising financial costs and even causing bankruptcy in the long run.

It is worth noting that debt, also called leverage, is healthy up to a point, because it gives the company the chance to grow in the market, increasing the return on equity.

However, debt growth without control and ratio analysis can ruin an organization, something observed for many years. That is why good financial planning matters so much.

See, in this infographic, the importance of KPIs in your management:

What are the types of debt?

Basically, a company can go into debt with third parties, that is, suppliers, banks and investors, in two ways:

• short term;
• long term.

Short-term debt is debt that must be paid in less than 12 months, while long-term debt is paid over a period longer than that.

Even so, in basic terms long-term debt does less damage to a company’s cash than short-term debt. Examples of long-term debt include:

• real estate financing;
• working capital paid in installments over more than 12 months;
• machinery financing;
• vehicle financing.

Examples of short-term debt include:

• receivables advances;
• terms granted by suppliers;
• loans paid in less than 12 months.

Because it is more harmful to the company, short-term debt should be avoided, except for supplier terms, which carry no interest when paid strictly on time.

Also download:

• E-BOOK: Build your Performance Indicators dashboard in 3 days!opens in a new tab (in Portuguese)

What are the debt ratios?

Now that we have shown what debt ratios are and why they matter to the organization, let’s take a deeper look at the 6 most widely used.

1. Third-Party Capital Share (TCS)

This ratio shows how much of the organization’s resources come from third-party capital. With it, you can tell the company’s level of debt. It is calculated with the following formula:

• TCS = (Current Liabilities + Long-Term Liabilities) / (Current Liabilities + Long-Term Liabilities + Shareholders’ Equity)

Here, current liabilities represent short-term debt and long-term liabilities represent long-term debt. Shareholders’ equity represents the company’s own capital.

So the higher the TCS, the higher the company’s level of debt, which means greater vulnerability to market surprises. When the TCS exceeds 1, the company becomes insolvent.opens in a new tab

To define a company’s strategic KPIs, there must be an identification process. This infographic can help:

2. Debt Composition (DC)

The Debt Composition ratio shows how much of the company’s debt is concentrated in the short term. The higher that concentration, the more difficulty the company may face in meeting its commitments.

On the other hand, the lower the concentration of debt in the short term, the better the company’s cash flow, and the more time it has to act in the face of market turbulence. The formula for this debt ratio is:

• DC = Current Liabilities / (Current Liabilities + Long-Term Liabilities)

In this context, the higher the DC, the more concentrated in the short term the company’s debt is, and the greater the risk of insolvency.

It is worth noting that receivables advances, which consist of bringing to present value the receipt of securities due in 30, 60 and 90 days by paying interest, are extremely costly for the company, which should avoid this resource as much as possible.

3. Fixed Assets to Equity (FAE)

This ratio shows the state of the company’s capital structure. Here, when a company ties up too much of its equity, less of its own resources are available.

In this case the company becomes more dependent on third-party capital to finance its current assets, which are usually made up of:

• inventory;
• cash;
• accounts receivable.

To find the degree of Fixed Assets to Equity (FAE), apply the following formula:

• FAE = Fixed Assets / Shareholders’ Equity

Fixed assets are the company’s permanent assets, which can be machinery, vehicles, buildings and land it owns. In this sense, the higher the FAE, the more capital is tied up in fixed assets relative to shareholders’ equity.

In other words, as the FAE grows, the company’s insolvency risk also grows. Do not confuse growth in the FAE with growth in fixed capital by itself.

When fixed capital grows but shareholders’ equity grows in the same proportion, the FAE holds steady, and the company does not become less insolvent.

But when fixed capital grows and shareholders’ equity stays the same, the FAE grows, showing that the company is taking capital out of current assets and placing it in fixed assets, creating more risk of insolvency.opens in a new tab

4. Fixed Assets to Long-Term Funds (FALF)

Another debt ratio is the FALF, which shows how much of the long-term resources and shareholders’ equity the company puts into its fixed capital.

This ratio also shows the state of the company’s capital structure. It lets you see how much was invested in fixed assets relative to long-term debt and shareholders’ equity.

The formula for Fixed Assets to Long-Term Funds is:

• FALF = Fixed Assets / (Long-Term Liabilities + Shareholders’ Equity)

The higher this ratio, the greater the chance the company will have trouble meeting its commitments.

Note that, for teaching purposes, the ideal is for fixed assets to be equal to or lower than long-term liabilities. That shows these assets are being financed with long-term debt and are not coming out of the company’s equity.

When fixed assets exceed long-term liabilities, they are being financed not only by long-term debt but also by company capital that could be invested in current assets to ensure more liquidity for its payments.

5. Overall Debt Ratio (ODR)

The overall debt ratio is one of the most basic debt ratios of a company, and it represents the proportion of debt compared to the business’s total assets. It is the one that shows the organization’s degree of leverage.

The higher this ratio, the more indebted a company is. Even so, it needs to be tracked together with the previous ratios, especially the DC, because on its own it may indicate a good level of debt while the debt is concentrated in the short term and hurting the company’s liquidityopens in a new tab. It is calculated as:

• ODR = (Third-party capital / Total assets) x 100

There is no exact value that defines a good level of debt for the ODR, since everything depends on the structure of that debt. Even so, when it exceeds 100%, the company risks insolvency.

For the ODR to sit at a good level of leverage, third-party capital must be lower than the organization’s total assets.

6. Financial Debt Ratio (FDR)

The financial debt ratio represents the relationship between the amount the company owes third parties and the amount invested by shareholders, and it is calculated as:

• FDR = (Gross Debt / Shareholders’ Equity) x 100

Note that the difference between financial debt and overall debt is that it evaluates debt relative to shareholders’ equity, which is the company’s own capital.

Overall debt, on the other hand, represents the percentage of debt over all the company’s assets, which were acquired with both its own capital and third-party capital.

In this sense, an ODR above 100% is more worrying than an FDR above 100%, although neither case is advisable.

In general terms, the higher the FDR, the greater the debt relative to the company’s own capital, and the more leveraged it is. In case of market turbulence, a high degree of leverage can lead the company to insolvency.

How to use debt ratios in strategic decision-making

Using debt ratios in strategic decision-making is a fundamental practice for the effective financial management of any company. These ratios provide valuable insights into the company’s capital structure, the sustainability of its debt and its ability to meet financial obligations.

In the BSCopens in a new tab methodology, we learn that the financial perspective is not the only one to consider when identifying whether the company is on the right track. Even so, you can use debt ratios to make strategic decisions such as:

1. Capital management and debt structure

Debt ratios help determine the ideal capital structure for the company. A high proportion of debt can indicate elevated financial risk, while a very low proportion can suggest the company is not taking advantage of leverage opportunities.

2. Investment planning

When considering new investments, it is crucial to evaluate how they will affect debt ratios. Investments that significantly increase debt may not be viable if the company is already highly leveraged. On the other hand, a healthy level of debt can allow strategic investments that drive growth.

3. Risk and sustainability assessment

Ongoing analysis of debt ratios is vital to assess the long-term sustainability of debt. This is especially important in uncertain economic environments, where market conditions can change quickly. Effective debt management helps minimize financial risk and ensure the company’s stability.

4. Communication with investors and stakeholders

Finally, debt ratios are fundamental in communicating with investors and other stakeholdersopens in a new tab. They give a transparent view of the company’s financial position, which is crucial for maintaining investor confidence and for negotiations with creditors and suppliers.

How to calculate debt ratios?

To calculate debt ratios, the company needs to have its balance sheetopens in a new tab (in Portuguese) prepared. In other words, all the accounts mentioned in the formulas come from the company’s balance sheet.

The accounting department prepares this balance sheet, as well as the income statement that shows the organization’s net profitopens in a new tab (in Portuguese). Through an inventory, it takes stock of all the company’s assets, which can be:

• inventory;
• accounts receivable;
• cash;
• machinery;
• vehicles;
• buildings.

These assets are divided into current, when they come in and out of the company more often, such as inventory, accounts receivable and cash, or fixed, when they stay on the balance sheet longer, such as machinery, vehicles and buildings.

The accounting department also takes stock of the company’s liabilities, that is, its obligations, which can be:

• accounts payable to suppliers;
• taxes due;
• fixed costs due;
• long-term loans and financing.

The difference between assets and liabilities results in shareholders’ equity, which should be on the liabilities side of the balance sheet, since it represents the own capital that also finances the company’s assets.

The sum of assets must always equal the sum of liabilities when shareholders’ equity is included. With this data in hand, just plug the values into the formulas and find the ratios.opens in a new tab

Strategic planning is essential for bringing down high levels of debt. To help you, we prepared a list of the best strategic planning tools. Check it out: Strategic planning tools and systems: the 7 best!

How to analyze debt ratios?

The analysis of debt ratios should be done the way we described in the article. In other words, the higher they are, the greater the risk of the company becoming insolvent.

It is worth noting that each ratio complements the others, so all of them should be calculated, and analyzing them together lets the organization make more accurate decisions.

In this sense, when the company sees one ratio growing too much, it needs to identify why that debt is growing and take decisions to reverse the picture, which can even include increasing the own capital on its balance sheet.

One of the best ways to collect data, generate the ratios and track them is with specialized software. It prevents the work from being done manually, which wastes time and can lead to errors.

And when it comes to cutting-edge software for analyzing debt ratios, one that stands out on the market is Stratws.

With it, you can track ratios and make decisions to improve the company’s financial health faster. Get to know our solution: