2. Debt ratios

The most popular version of the debt ratio expresses the firm's total liabilities as a percentage of the book value of total assets:

  

Debt ratio = \( \frac{\text{Total liabilities}}{\text{Total assets}} \).

  

Strictly speaking, the above ratio is not a "debt ratio" but a "liability ratio." The reason is that it considers all the firm's liabilities in the numerator, including operating liabilities such as accouts payable and deferred taxes. But the common practice is to call it a debt ratio. 

To get a clearer picture of the firms actual financing structure, it makes sense to compute the so-called debt-to-capital ratio. This ratio only focuses on the firm's actual "debt," that is, its financial liabilities. It expresses these financial liabilities as a percentage of the invested capital from the debt- and equityholders:

 
Debt-to-capital ratio = \( \frac{\text{Financial liabilities}}{\text{Financial liabilities} + \text{Book equity}} \).
 
 

Turning again to Hershey's financials in 2015, we know from the firm's balance sheet (in millions of USD):

  • Total assets in 2015: 5'344.4
  • Total liabilities in 2015: 4'296.9
  • Financial liabilities in 2015: 2'420.5; Short-term debt (363.5), current portion of long-term debt (499.9), and long-term debt (1'557.1).
  • Total equity in 2015: 1'047.5

 

The numbers imply a debt ratio of 80.4% and a debt-to-capital ratio of 69.8%:

 

Debt ratio = \( \frac{\text{Total liabilities}}{\text{Total assets}} = \frac{4'296.9}{5'344.4} \) = 0.804 = 80.4%.

 

Debt-to-capital ratio = \( \frac{\text{Financial liabilities}}{\text{Financial liabilities} + \text{Book equity}} = \frac{2'420.5}{2'420.5+1'047.5} \) = 0.698 = 69.8%.

 

Therefore, it looks as if Hershey relied pretty heavily on debt financing. As a comparison, General Mills had a slightly smaller debt ratio of 71.9% at the end of its 2015 business year.

 

Yet another important issue when computing debt (and later leverage) ratio is the question whether we rely on book values or on market values. This is especially critical when it comes to the equity component of the financing structure, as the book value of debt is generally close to its market value. So far, we have used book values. 

To see how relevant this distinction is, consider, again, Hershey. We have established that the firm's book value of equity was 1'047.5 million at the end of 2015. In contrast, the firm's market value of equity (share price × number of shares outstanding) was approximately 19'400 million at the end of 2015. Consequently, we find the following debt ratios if we replace the book value of equity with its market value:

  

 \( \text{Debt ratio}_{Market} = \frac{\text{Total liabilities}}{\text{Total assets} - \text{Book equity} + \text{Market equity}} = \frac{4'296.9}{5'344.4 - 1'047.5 + 19'400} \) = 0.181 = 18.1%.

 

 \( \text{Debt-to-capital ratio}_{Market} = \frac{\text{Financial liabilities}}{\text{Financial liabilities} + \text{Market equity}} = \frac{2'420.5}{2'420.5+19'400} \) = 0.111 = 11.1%.

 

Because the market value of the equity is so much larger than its book value, the debt ratio drops from 80% to 18% when switching from book values to market values. The corresponding decrease in the debt-to-capital ratio is from 70% to 11%.

 

Which ratios to use? The answer generally depends on the specific situation that we want to analyze:

  • If we are interested in a liquidation scenario (for example to stress-test a financing policy), it might make more sense to focus on book values.
  • In turn, if we are interested in a going-concern scenario, market values might be more appropriate because they reflect all market expectations about the firm's future development.