Essential Indicators to Check When Investing in a Company: What is the Debt Ratio?

One of the important indicators that you must check when investing in a company is 'Debt Ratio'and we will discuss it in this post.

Essential Indicator for Corporate Investment: Understanding Debt Ratio

Debt ratio is one of the representative indicators for evaluating the financial soundness of a company, which refers to the ratio of a company's total debt to its equity. In other words, it is an indicator that shows how much debt a company has relative to its own capital.

It is mainly used by financial institutions and investors to evaluate a company's ability to repay loans and its creditworthiness. Generally, if the debt ratio is 100% or less, the company's financial condition is considered sound, and if it is 200% or more, it is considered a risky level.

For example, if Company A has equity of 100 million won and total debt of 200 million won, the debt ratio is 200%. On the other hand, if Company B has equity of 300 million won and total debt of 150 million won, the debt ratio is 50%. In this case, it can be judged that Company B has a relatively stable financial condition.

Investors need to analyze various financial indicators, including the debt ratio, to understand the company's business conditions and future growth potential and make appropriate investment decisions.

Why Debt Ratio is Important and its Value in Corporate Analysis

Debt ratio is one of the important indicators that shows the overall financial status of a company. There are several reasons why it is important.

• Debt ratio indicates a company's debt repayment capacity. Companies with high debt ratios are more likely to face difficulties in paying interest and repaying principal. This can lead to bankruptcy or other financial crises, posing a risk factor for investors.
• It allows you to understand the company's financing method and the associated interest costs. The more debt a company uses, the higher the interest costs, which can affect profitability. Therefore, investors need to consider this when making investment decisions.
• It helps predict a company's growth potential and sustainability. Companies with low debt ratios can pursue active investment and growth based on a stable financial structure, while companies with high debt ratios may face limitations on growth due to excessive debt burdens.

How to Calculate Debt Ratio and Real Case Analysis

Debt Ratio is a ratio that divides a company's total liabilities by its equity, and it is one of the representative indicators to evaluate the soundness of a company's financial structure. The formula is as follows:

• Debt Ratio = (Total Liabilities / Equity) x 100%

For example, if Company A has total liabilities of 100 billion won and equity of 50 billion won, the debt ratio is 200%.

Let's calculate the debt ratio of Samsung Electronics based on the 2022 third-quarter financial statements as a real-world example. As of the end of the quarter, Samsung Electronics' total liabilities were approximately 309 trillion won, and its equity was approximately 352 trillion won.

Therefore, by substituting it into the above formula, we can see that Samsung Electronics' debt ratio is 87.8%. We can confirm that it maintains a debt ratio that is lower than the industry average, which means that Samsung Electronics has relatively high financial soundness.

Based on the calculated debt ratio, you can judge the company's financial status and refer to it when deciding whether to invest.

Stable Range of Debt Ratio and Differences by Industry

Generally, if the debt ratio is 100% or less, it is considered favorable, and if it exceeds 200%, it is considered risky. However, this is not an absolute standard, and the appropriate level of debt ratio can vary depending on the industry.

In the manufacturing industry, the debt ratio tends to be relatively high because large-scale fund raising is required for facility investment, while the financial industry has a relatively low debt ratio because it operates based on customer deposits. Also, even within the manufacturing industry, there are cases where the debt ratio increases, such as in the shipbuilding industry, where the ship construction period is long.

Meanwhile, recently, there is a trend to comprehensively evaluate the financial soundness of a company using various financial indicators such as debt-to-asset ratio and times interest earned, in addition to the debt ratio. The debt-to-asset ratio is an indicator that shows the proportion of debt in total assets, and 30% or less is considered an appropriate level. Times interest earned is a value obtained by dividing operating income by interest expense, and if it is 1 or more, it is judged that operating income can cover interest expenses.

Impact of High Debt Ratio on Companies

A high debt ratio means that a company relies more on debt (other people's capital) than on equity. This can have the following negative impacts.

• Worsening profitability due to increased interest expense Interest on debt is one of a company's fixed costs, and the higher the debt ratio, the higher the interest expense. This can reduce a company's net income and worsen its profitability.
• Liquidity risk due to increased repayment pressureThe higher the debt ratio, the more pressure creditors can put on repayment, which can worsen a company's liquidity. If a company fails to secure sufficient liquidity, it may lead to a default (debt default).
• Difficulty in fundraising due to a decline in credit ratingA high debt ratio is one of the factors that can lower a company's credit rating. If the credit rating declines, the cost of raising funds for the company increases, and it may become difficult to raise funds.
• Threat to management rightsIf creditors sell the shares they have pledged as collateral to increase pressure for repayment, management rights may be threatened.

Strategies for Utilizing Debt Ratio in Investment Decisions

Debt ratio is one of the important indicators that shows the financial status of a company, and it can be actively utilized when making investment decisions. Here are some strategies that utilize debt ratio.

• Select companies with low debt ratios for safe investment Generally, companies with a debt ratio of 100% or less are considered relatively safe. However, the criteria may vary depending on the industry or company characteristics, so it is good to compare them with the average debt ratio of the industry.
• Analyze companies with high debt ratios to find companies with high growth potentialEven if the debt ratio is high, if the company has high growth potential, you can make an investment decision by accepting it. At this time, you must also consider the times interest earned (Operating Income / Interest Expense)of the company.If the times interest earned is less than 1, it means that the company cannot even cover its interest expenses with operating income.
• Check the trend of the debt ratioEven if the debt ratio has temporarily increased, if the trend is improving, the future outlook may be positive. Conversely, if the debt ratio continues to increase, it means that the company's financial status is worsening, so caution is needed.

Conclusion

As you can see, various information that we may not have known is contained in financial statements. So, if you are considering stock investment or business planning, please take a look at it once.