What Does Debt Ratio Mean In Stock Trading?

What Does Debt Ratio Mean In Stock Trading?

Stock trading and investing can be a highly complex process that involves hours of research to pick the right stocks for your investment objectives. 

Fundamental analysis is the process of analyzing the factors directly related to the performance of the underlying company, such as financial results, governance, long-term strategy, etc. 

One important fundamental factor to consider is the balance sheet, which shows the number of total assets, liabilities, and equity attributable to the company. 

Debt is arguably the most noteworthy type of liability a business can have, which also affects the stock performance.

When a company is heavily burdened with debt, investors may be less inclined to buy its shares, as debt accrues interest that must be paid regularly by the company. 

Investors and analysts use various debt ratios to assess the financial health of the balance sheet of a business to decide whether investing carries outsized risks. 

If you are a beginner trader and would like to know more about what a debt ratio is, this Investfox guide is for you. 

What Are Debt Ratios?

Debt ratios are crucial metrics in stock analysis as they provide insights into a company's financial leverage and its ability to meet its debt obligations.

Depending on the other variable in the ratio, debt ratios can give great insight into how well the company can manage its debt obligations and if not, where the major issues may lie.

Here are some commonly used debt ratios used in stock analysis:

  • Debt-to-Equity Ratio (D/E): Indicates the proportion of a company's financing that comes from debt compared to equity. A higher ratio implies higher financial leverage
  • Interest Coverage Ratio: Measures a company's ability to cover its interest expenses with its operating income. A higher ratio suggests better debt-servicing capacity
  • Debt Ratio: Shows the proportion of a company's assets financed by debt. A lower ratio indicates less reliance on debt for asset financing
  • Debt to Capitalization Ratio: Reflects the percentage of a company's capitalization that comes from debt. A higher ratio implies higher financial risk
  • Current Ratio: Measures a company's short-term liquidity. While not a direct debt ratio, it helps assess a company's ability to cover its short-term liabilities
  • Quick Ratio (Acid-Test Ratio): Similar to the current ratio but excludes inventory. Provides a more conservative measure of a company's ability to meet short-term obligations

Debt Ratio Formulas

Most debt ratios have quite straightforward formulas that are easy to calculate. Here are the formulas for the aforementioned debt ratios:

Debt to Equity Ratio = Total Debt/Total Equity

Interest Coverage Ratio = EBIT/Interest Expense

Debt Ratio = Total Debt/Total Assets

Debt to Capitalization Ratio = Total Debt/(Total Debt + Total Equity)

Current Ratio = Current Assets/Current Liabilities

Quick Ratio = (Current Assets - Inventory)/Current Liabilities

Using these debt ratios, investors can assess the ability of a company to pay off its debts. If the ratios show high values, this may mean that the company is overburdened with debt, which could cause difficulties in the long term. 

Debt Ratio Example - Apple Stock

apple balance sheet.png

To better understand how debt ratios work in practice, we can calculate the debt ratio of Apple Inc to see how well the company can manage its debt load. 

According to the 2022 full year financial report, Apple has a total debt figure of $111,88 billion and assets over $352,58 billion.

The debt to asset ratio adds up to 0.317, which means that almost a third of Apple’s assets are derived from debt. 

Such a ratio may be problematic for most other companies, but since Apple is a consistently profitable corporation with global reach, the debt ratio is of less concern to its long-term shareholders. 

Key Takeaways From What Does Debt Ratio Mean

  • The debt ratio is a financial measure that indicates the company’s ability to pay its financial liabilities while providing insight regarding its overall financial health 
  • There are various debt ratios, such as debt-to-equity, debt-to-assets, the current ratio, quick ratio, and more, with each indicating how a company’s debt relates to other financial metrics 
  • A high debt ratio could mean that the company does not have the ability to easily pay back its debt, leading to potential insolvency issues in the future
  • Investors use such metrics to decide whether a stock is viable as a long-term investment or not and how likely solvency issues may be for the company 

FAQ On Debt Ratio

What do debt ratios show?

Debt ratios, such as debt-to-equity, debt ratio, and interest coverage, reveal a company's financial leverage, debt management, and ability to meet obligations. They help investors assess risk, financial health, and the company's reliance on debt for financing.

Are debt ratios useful in stock trading?

Yes, debt ratios are crucial in stock trading. They provide insights into a company's financial health, risk, and ability to meet obligations. Traders use these ratios to assess investment risks, make informed decisions, and manage portfolios effectively.

Is a high debt ratio bad?

A high debt ratio can be concerning, as it indicates higher financial leverage and increased risk. While some level of debt is common, excessively high debt ratios may lead to financial instability, higher interest expenses, and challenges in meeting debt obligations.