Debt ratio is pretty easy to understand, right? It basically just counts how much money you have total, and of that, how much is yours versus how much is borrowed. That is the calculation. But the main point here isn't to explain how to calculate the debt ratio. It is to explain the ability to pay off debt.
Let's assume there are two people. One is a surgeon with a stable job making 400k a month. The other is an artist with a super unstable income making 40k a month. They both carry the same 5 million mortgage. Do you think their financial risk is the same? The answer is obvious.
Applying the "debt ratio" to evaluate a company's financial risk works the exact same way. If you see 60%, does that definitely mean high risk? If you see 40%, does that definitely mean low risk? Aside from the debt number itself, you have to check the quality of the debt and the ability to repay it. You want to reduce as many blind spots as possible when evaluating a business.
The debt ratio formula
Debt Ratio = (Total Liabilities / Total Assets) × 100%
The concept is pretty simple. The Debt Ratio just tells you what percentage of a company's total assets is "borrowed." It is one of the most basic metrics for a financial health check.
Like we mentioned when we talked about the Balance Sheet, assets are made up of Liabilities plus Shareholder Equity. The Debt Ratio just calculates exactly how big of a slice those "Liabilities" take out of the total assets.
Is a lower debt ratio always better?
Most people instinctively think "the lower the debt ratio, the better." But is that really the case?
- The lower the better: A company with zero debt sounds super safe, but it might also mean they are being too conservative. They might not know how to use financial leverage to grab opportunities for expansion or speed up growth. When interest rates are low, borrowing a moderate amount to invest can often generate higher returns for shareholders.
- High leverage: On the flip side, running a business with too much debt is like playing with fire. Sure, it can magnify your profits and create amazing results when you have tailwinds. But once the economy turns or you hit industry headwinds, that massive pressure from interest payments will snowball. Best case, it eats up your profits. Worst case, it triggers a bankruptcy crisis.
What is a reasonable debt ratio?
There is no such thing as a perfect standard number for the Debt Ratio, but generally speaking, keeping it under 60% is considered the safe zone.
So, aside from that, how can value investors judge if a company's debt is actually "reasonable"? You can use the Interest Coverage Ratio and Free Cash Flow to cross-check the Debt Ratio. This helps you gauge the current risk and ability to pay, which is way more useful than just staring at the debt ratio alone.
Interest coverage ratio
Interest Coverage Ratio = (Annual Pre-Tax Income + Annual Interest Expense) / Annual Interest Expense
This metric checks how much cushion the company's earnings provide for paying off interest. It is your first line of defense when assessing their ability to pay off debt.
Think of it like asking, "How many times does my monthly salary cover my mortgage interest?" If you make 200k a month and your interest is 20k, your coverage ratio is 10 times. That means you have a huge financial cushion to handle surprises. But if you make 22k and your interest is 20k, your coverage is only 1.1 times. Any little bump in the road could send you into a crisis.
Why do we add the Interest Expense back in the top part of the formula? Because Pre-Tax Income is the number after interest has already been deducted. Adding it back shows "the money you earned before paying any interest." Anyway, that is just accounting logic. If it doesn't make sense, feel free to skip it.
Generally speaking, if this ratio stays steadily above 5 times, it means the company has a pretty solid margin of safety. That lets investors sleep a lot better at night.
Free cash flow
If the Interest Coverage Ratio is the first line of defense, then Free Cash Flow is the ace up your sleeve for measuring their ability to pay.
We mentioned in previous articles that Free Cash Flow is the "real cold hard cash" left over after paying for all operating expenses and future investments. This is the money that is actually free to use. It is the ammo the company uses to pay off debt, hand out dividends, or fund acquisitions.
Real-world example: TSMC vs. Evergreen. Whose debt is actually safer?
Let's take a look at two titans of Taiwanese industry: the semiconductor leader TSMC (2330.TW) and the shipping giant Evergreen Marine (2603.TW). TSMC represents the kind of company with massive, steady cash flow that uses debt strategically. Evergreen is a top-tier, massive shipping company, but it operates in a highly cyclical industry.
If we just look at the debt ratio on the surface, we might jump to a totally misleading conclusion. That is why you have to look at "Debt Ratio + Interest Coverage Ratio + Free Cash Flow" all together.
Evergreen's debt ratio is actually slightly lower than TSMC's. If you stopped there, you would wrongly conclude that "Evergreen has a safer financial structure than TSMC".
So let's bring in the Interest Coverage Ratio. TSMC has stayed above 82 times for the past three years. That means their risk of defaulting on interest is basically zero. While Evergreen's 35 times in 2024 is still healthy, its profit cushion has shrunk significantly.
Finally, look at Free Cash Flow. TSMC is like a money-printing machine that just keeps cranking out cash. Even with huge capital expenditures, it still generates hundreds of billions of NT dollars in free cash flow every year. Evergreen's cash flow, on the other hand, is tied tight to the shipping cycle. When the cycle is down, it can even drop into the negative.
It is not that Evergreen has a bad ability to pay off debt, but when you compare the two, you can clearly see the gap.
Factor in the ability to pay back debt
After going through all that info, you will realize that regarding debt, you have to consider the ability to repay it to see the full picture. A company with a 40% debt ratio might actually be on more solid financial ground than a cyclical company sitting at 34%. Of course, it is still generally ideal to keep that debt ratio under 60%.
From now on, whenever you see a debt ratio, you will naturally start digging deeper. Check the Interest Coverage Ratio, see if the Free Cash Flow is solid, and look at how resilient the business model is. That is how you figure out a company's true financial health.
