Debt is a natural part of business. The most volume (number of transactions) of debt occurs with the simple purchase of materials (inventory) or supplies on account. Every business buys on account whether it is a traditional vendor account like that found in retail or simply using a credit card. A third party provides credit which creates debt for the business. The debt ratio reflects the percentage of assets covered by debt. The formula is as follows:
Debt Ratio = Liabilities
Most small businesses have difficulty finding private capital for equity to fund assets especially assets for the expansion (growth) of a business. Assets are funded from two sources. The first source is equity which is customarily composed of the sale of ownership shares – stock and retained earnings (which are the lifetime retained profits from operations). The second source of capital to buy assets is from debt. Borrowing money is easier than obtaining capital equity. It is especially easier if the debt is collateralized like that required with bank loans. This chapter in the business ratio series explains the two underlying parts of debt, short and long-term liabilities. In addition it will explain how they are calculated. This chapter goes further to elaborate on debt in comparison to the assets reported. Furthermore, leverage with debt is explained and why leverage is safer with some businesses and extremely risky with others. Finally, there are some nuances with debt that a reader should be aware of and how to discover and evaluate these critical aspects of debt. When done, the reader will have a greater appreciation of the debt ratio and how to apply this formula in evaluating performance of a business.
Debt Ratio Formula
A typical balance sheet is composed of three major sections.
1) Assets – Tangible (physical) and intangible items used to provide products or services to customers. The most prized asset is cash. Assets are considered one side of a balance sheet.
2) Liabilities – Amounts owed to third parties for products or services rendered. Most liabilities reflect financing of assets.
3) Equity – The value or portion of assets that is owned or funded by owners of the company. It includes stock, retained earnings and current earnings.
The debt ratio is merely the percentage of total assets funded with third-party money. It is one of the leverage group of ratios. Below is a simple balance sheet and the corresponding debt ratio.
SMALL TOWNE BOOKS, INC.
Balance Sheet (Summary Format)
December 31, 2016
Current Assets $297,403
Fixed Assets (Netted) 68,997
Other Assets 14,471
Total Assets $380,871
Current Liabilities $207,651
Long-Term Liabilities 102,382
Sub-Total Liabilities $310,033
Common Stock $50,000
Retained Earnings 17,200
Current Earnings 3,638
Sub-Total Equity 70,838
Total Liabilities and Equity $380,871
The debt ratio equals liabilities divided by assets.
Debt Ratio = $310,033 = 81.4%
The debt ratio is really a summation of two elements of debt. Notice that liabilities are composed of current (short-term) and long-term liabilities. Both are compared against total assets for their respective percentage. Added together they equal the total debt ratio. Look at the results:
Short-Term Debt Ratio = Current Liabilities = $207,651 = 54.52%
Total Assets $380,871
Long-Term Debt Ratio = Long-Term Liabilities = $102,382 = 26.887%
Total Assets $380,871
Equals Total Debt Ratio = 81.407
It is important to understand these two sub ratios have an interaction with each other as different industries will tend towards certain relationships.
Debt Ratio Relationships
All industries tend towards certain debt relationships on their respected balance sheets. For example, power generation companies make huge investments into plant, equipment and electrical distribution lines (grid). These investments are truly long-term (> 30 years) and therefore they are financed with long-term debt (usually bonds). If you look at a balance sheet for a power generation company you’ll find a 10:1 or higher ratio of fixed assets in comparison to current assets (cash, receivables and inventory).
The balance sheet’s liability section will tend towards a similar relationship associated with its current and long-term liabilities. In effect, the long-term debt will be greater than 10 times the volume of short-term debt. This relationship is essential as the asset structure should have a similar debt structure.
Let’s go back to the bookstore and evaluate its reasonably expected relationship and its actual relationship.
If you can imagine a bookstore, it is a shelving system loaded with books. It is not unreasonable to expect fixed assets to be less than current assets in value. After all, it isn’t as if book shelves are highly customized fixtures. Long-lived assets will more than likely have financing that is long-term. Here is the comparison in dollars:
SMALL TOWNE BOOKS, INC.
Fixed Assets Long-Term Debt
In general, long-term debt should always be less than the corresponding fixed assets value; as more than likely, long-term debt was used to purchase fixed assets (long-lived assets). In this case, there is a poor matching of one asset group to its corresponding source of financing.
Take a look at current assets financing with current liabilities.
Current Assets – $297,403
Current Liabilities – $207,651
This ratio is 69.7% of current liabilities to current assets giving this relationship a current ratio of 1.43:1 (which is fair). It is plainly obvious that some of the current assets are financed with long-term debt and/or equity. In small business, this is actually normal. This is because small business owners often loan money to the company and agree to subordinate their position to the secured creditors. Sometimes the owners borrow money from the bank and personally guarantee the loan or use their personal fixed assets (equity in real property) as collateral. As a small business matures, often the long-term debt comes more in line with what an investor will find with publicly traded companies in a similar industry.
However, think about the bookstore business. There are three major assets; one is cash, the second are books and the third are shelves. Shelving is generally financed with long-term debt as explained above. However, books, magazines and publications are all short-term assets. The idea is to get them sold within 90 days (magazines within 30, publications within a few days). Therefore books are financed with vendor accounts. Some vendors will extend credit to 90 days or longer; but in general the secret to this business is the inventory turnover rate. What an investor will look to in this business is the relationship of inventory to vendor accounts. Any value greater than 1:1 (inventory value is more than payables) is a positive sign of financial management.
Ideally, an investor is looking for the company to finance a good portion of assets with equity and not debt. Why? Well lets look at two common public company drawbacks associated with too much debt.
Many publicly traded companies use debt to finance all of their fixed assets. Good examples include research businesses (chemicals, pharmaceuticals, oil exploration), airlines, shipyards, finance and real estate (REITs, apartment complexes, resorts). For these businesses, any slow down in economic activity greatly impacts their revenue stream and ability to service debt. Failure to service debt results in default and ultimately bankruptcy.
If the company is highly leveraged, borrowing capacity is restricted. If the business has an opportunity to expand via vertical integration or geographically, banks will deny the additional credit needed. It is no different than you or I maxing out our credit cards; an emergency will be an issue.
A reasonable amount of equity is necessary to reduce the debt ratio and provide for potential opportunity.
Proper Application of the Debt Ratio
There are situations where debt is appropriate in business. Some of the better examples are directly tied to the long-lived assets such as heavy equipment, land, structures, utilities and infrastructure. The idea is to match the assets life with debt of a slightly shorter duration (approximately 75 – 80%). The shorter duration ensures the bank will get paid back before the asset wears out. In addition, a good portion (at least 25%) of the asset’s purchase price is paid from equity funds (excess working capital).
Let’s take a look at this site development company’s balance sheet for the purpose of evaluating a proper debt ratio and corresponding debt components.
JC’S EXCAVATION INC.
Balance Sheet – (Detailed Format)
December 31, 2016
– Cash $672,409
– Work in Process 2,483,792
Sub-Total Current Assets $3,156,201
– Land $175,000
– Heavy Equipment 3,971,600
– Other 406,200
Sub-Total Fixed Assets 4,552,800
TOTAL ASSETS $7,709,001
– Payables $203,716
– Project Billings 1,961,450
– Other 162,793
Sub-Total Current Liabilities $2,327,959
– Heavy Equipment Notes $1,843,552
– Other Notes 163,641
Sub-Total Long-Term Liabilities 2,007,193
TOTAL LIABILITIES 14,335,152
– Common Stock $385,000
– Retained Earnings 2,376,500
– Current Earnings 612,349
TOTAL EQUITY 3,373,849
TOTAL LIABILITIES AND EQUITY $7,709,001
First calculate the respective debt ratios:
Current Debt Ratio = $2,327,959 = 30.20%
Long-Term Debt Ratio = $2,007,193 = 26.04%
Total Debt Ratio = $4,335,152 = 56.24%
Now, let’s break it down further. Notice that work in process has been partially financed with project billings (construction companies bill as they finish phases in a project; project billings should never exceed work in process). This means the balance, $522,342, was funded from other sources, namely payables and equity. The real relationship of importance is the long-lived assets and the corresponding long-term liabilities. Within the fixed assets, heavy equipment is the focus along with its matching equipment notes. Let’s look at that ratio:
Heavy Equipment Debt Ratio = $1,843,552 = 46.4%
This is an exceptionally positive ratio. It indicates low leverage which provides the ability to take advantage of an opportunity. Now let’s explore this.
JC has an opportunity to sign a road contract which will generate a 25% increase in revenue in 2017. To do this JC must add $800,000 of heavy equipment to his fixed assets. The bank will allow a 65% position of long-term debt to heavy equipment value. How much can JC borrow to finance this equipment?
Present Value of Heavy Equipment $3,971,600
Additional Equipment Needed 800,000
Total Heavy Equipment Value 4,771,600
65% Debt Ratio 3,101,540
Present Heavy Equipment Debt 1,843,552
Borrowing Capacity $1,257,988
JC can borrow all $800,000 and not exceed the 65% maximum debt capacity for heavy equipment.
Here are some guiding principles related to the debt ratio:
A) The debt ratio is all liabilities as a percentage of all assets.
B) Break the debt ratio down into the two core elements of current and long-term debt.
C) Break each of the two core elements down further into the primary relationships:
– Inventory to vendor payables
– Work in process to project billings and accounts payable
– Receivables against the line of credit
– Equipment to their respective loans/notes
– Real estate against its mortgage.
D) Look for significantly dissimilar relationships to discover advantages or unfavorable financial positions.
Risky Debt Ratios
As an investor, your goal is to reduce your risk of loss associated with your investment. Spotting risky debt ratios and their corresponding relationships is essential to separate yourself from novice investors. The secret lies in the notes to the financials. In a typical business the fixed assets are reported like this:
Property, Plant and Equipment $9,750,000
Accumulated Depreciation (6,943,500)
Net Fixed Assets $2,806,500
For this example, the associated long-term notes for the equipment states $6,000,000. This means the long-term debt to fixed assets isn’t 50 or 60%, it is 214%. Immediately you’ll think that this is a red flag for an investment. Look at the details. The details are in the notes. Go to the notes section for fixed assets first.
Notice in the above accumulated depreciation is $6.9 Million. If the depreciation taken each year matches the true utility (usage) of the equipment then indeed the fixed assets debt ratio is way out of whack. But most companies use accelerated depreciation to account for depreciation which underestimates the net fixed assets value (accumulated depreciation is higher than actual utility lowering net fixed assets value). Most notes include a fixed assets life schedule that looks similar to this:
Asset Group Cost Basis Expected Life
Vehicles $1,206,000 5 – 7 Years
Equipment 1,943,000 7 – 12 Years
Plant 6,000,000 25 – 30 Years
Other 601,000 Infinite
This schedule clearly identifies that land (infinite) and the building are $6.6 Million of total asset pool at cost. Since real estate has a low bottom threshold, worse case is that the real estate component is worth $5.5 Million of the total $6,000,000 borrowed. The balance is for the other assets that are currently generating money in the form of revenue. Therefore the debt ratio is not really unrealistic given the details. Furthermore, there is a depreciation schedule for the respective assets in the notes section of the financials. Read both sets of notes to gain an understanding of the risk position associated with the long-term debt ratio.
Experience has taught me that accumulated depreciation rises quickly as a percentage of total assets at cost and then slowly increases towards the total asset cost over the remaining life of the asset(s). With the above example, this business is well along in its maturity and most likely the real estate represents a majority of value related to fixed assets. The best way to discover the details is to look at the tax return’s depreciation schedules which also lists the assets in detail, their respective purchase date book and tax depreciation. This report really clarifies the respective individual assets.
One other note is instrumental in evaluating the debt ratio. Notes should include long-term liabilities itemized descriptions and their corresponding principal payments. Here is an example that corresponds to the above fixed assets schedule.
* Mortgage Note – The company has a $5.7 Million mortgage deed of trust and corresponding note dated June 2, 2011 secured by land, structures and improvements. The note is a 20 year amortized amount with an interest rate of 1.2% over the LIBOR paid monthly. LIBOR is currently (March 24, 2017) at 2.6%. Minimum principal payments are $48,000 per year ($4,000 per month) escalating to $60,000 per year in the 7th year (2018). Current principal balance is $5,276,000. The following are the minimum expected principal payments schedule:
Year Minimum Required Principal
2020 – 2024 300,000
Beyond 2024 4,813,000
* Equipment Note – A bank equipment note secured by vehicles, plant equipment and tooling. The note is dated March 7, 2009 with a maturity date of March 6, 2019. The original balance was $1,725,000 with a current balance of $724,000. Monthly payments are $14,324 including interest at 5.75%. Any unpaid principal balance is due with the final payment.
A typical long-term liabilities note includes a summary report for total principal payments for all notes combined over the next three years by year and in groups (summation) of five years giving the reader an idea of anticipated cash flow out due to financing.
Using the combination of all three descriptive notes (fixed assets, depreciation and long-term debt) along with the tax return depreciation schedule, an investor can clarify the long-term liabilities to fixed assets debt ratio.
Summary – Debt Ratio
The debt ratio is simply total liabilities divided by total assets. An investor or user should break this debt ratio into its two sub-components of current liabilities to total assets and long-term liabilities to total assets. This percentage relationship allows the reader to understand how assets are financed with debt. Industries have historical relationships. Retail generally has a stronger current liabilities (debt ratio) whereas fixed asset intensive industries have a disproportionately weighted long-term liabilities debt ratio.
Once the two respected debt ratios are analyzed, the investor can then evaluate the individual liability groups to their respective assets including:
* Inventory financed by accounts payable,
* Work in process financed via progress billings and subcontractor payables,
* Accounts receivable are customarily tied to a bank line of credit,
* Fixed assets and the corresponding long-term notes.
To gain more knowledge about the respective long-term assets and liability notes read the corresponding descriptions in the notes section of the financial report. In addition, use the tax return to get detailed information related to depreciation.
Overall, the key to debt ratios is the test of reasonableness. Does the relationship appear normal given the asset and risks involved? The higher the debt ratio, the greater the exposure to economic recession and the less likely the business can take advantage of opportunities when they arise. Act on Knowledge.