Debt Ratio

What is the debt ratio?

Debt ratio (German: Verschuldungsgrad) denotes the ratio of a company's debts to a reference figure that describes their sustainability. The static debt ratio (debt-to-equity ratio) compares debt capital, that is, all debts according to the balance sheet, with equity. The dynamic debt ratio (leverage) puts net financial debt in relation to EBITDA. Net financial debt is financial debt less cash and cash equivalents; EBITDA is earnings before interest, taxes, depreciation and amortisation. The first form describes the financing structure on a reporting date, the second the ability to repay debts out of ongoing business.

Two haulage companies each have EUR 2 million of bank debt. One generates EUR 1 million before interest, taxes, depreciation and amortisation in a year, the other EUR 400,000. With the same amount of debt, the first thus owes twice and the second five times its annual earnings.

The ratio appears in banks' balance sheet analysis, in loan agreements as a financial covenant, in debt-financed company acquisitions and in valuation, because debt directly reduces the purchase price for the shares. Balance sheet analysis and rating often work with the static form, loan agreements and transactions almost always with the dynamic debt ratio.

Static debt ratio: formula and meaning

Formula: static debt ratio = debt capital / equity

Under the German Commercial Code (Handelsgesetzbuch, HGB), debt capital comprises provisions and liabilities. Depending on the analysis, deferred income is added, that is, payments received in advance for services still to be rendered. A value of 2.0 means that for every euro of equity there are two euros of debt capital. A narrower variant puts only net financial debt in relation to equity (gearing). Because the ratio is based on the book values of the balance sheet, it is also called the book-value-based debt ratio. For the cost of capital in business valuation, by contrast, market values are often used, for equity for example the stock market value.

The static debt ratio and the equity ratio describe the same fact from two angles. If debt capital equals the balance sheet total less equity, the following applies: debt ratio = (1 minus equity ratio) / equity ratio. An equity ratio of 25% thus corresponds to a debt ratio of 3.0. Both figures share the same weakness: they depend on accounting options and say nothing about whether the debts can be serviced out of the business.

Dynamic debt ratio: formula and debt repayment period

Net financial debt to EBITDA (leverage)

The form most widespread in financing and transactions puts net financial debt in relation to the EBITDA of the last twelve months. Net financial debt comprises financial liabilities such as bank loans, bonds and shareholder loans, less cash and cash equivalents. Depending on the contract, debt-like items that are treated as debt are added, for example pension provisions or vendor loans from earlier acquisitions. Some loan agreements exclude shareholder loans with a subordination agreement (Rangrücktritt). It is stated as a multiple: a dynamic debt ratio of 2.5 means that net financial debt equals two and a half times EBITDA.

Formula: dynamic debt ratio = (financial liabilities minus cash and cash equivalents) / EBITDA of the last twelve months

Debt repayment period

Classical balance sheet analysis also forms the dynamic debt ratio with a cash flow instead of EBITDA and then reads it as a debt repayment period in years. It is calculated as net financial debt divided by a cash flow, such as operating cash flow or free cash flow. It states in how many years the debts could in theory be repaid in full from ongoing business if no distributions are made and the cash flow stays constant. Compared with the EBITDA ratio, it takes account of taxes, working capital and, depending on the definition, investments.

Debt ratio in loan agreements and bank analysis

In loan agreements, the dynamic debt ratio is agreed as a financial covenant with an upper limit that must be met on set reporting dates (covenants). The permitted level depends on the sector, the stability of earnings, collateral and the type of financing; for acquisition financings it is regularly higher than for a working capital loan. What counts is the definition in the contract, which often provides for an adjusted EBITDA and its own delimitation of net financial debt.

If the upper limit is exceeded, the lender can, depending on the contract, terminate, raise the margin or demand additional collateral. The margin is the bank's interest mark-up. In practice, a breach is often cured by a waiver against a fee, an adjustment of the ratios or an equity injection from the shareholders. For the lending decision, what counts above all is debt service capacity, that is, the question of whether interest and repayment can be paid out of ongoing business. The debt ratio complements this view with the stock of debt.

Debt ratio in acquisitions, succession and venture debt

In debt-financed acquisitions by financial investors (leveraged buy-out), the dynamic debt ratio is the most important control variable of the financing. Financial investors buy companies in order to resell them after a few years. The acquirer finances part of the purchase price with acquisition loans that are serviced from the cash surpluses of the target company. The higher the leverage at acquisition, the lower the equity commitment and the stronger the effect of later deleveraging on the return.

How high the leverage may be at acquisition is determined by the lenders' willingness, which is guided by sustainable EBITDA and the predictability of cash flows. Similar considerations apply to a management buy-out in succession, that is, the purchase by the company's own management. There, a vendor loan often covers part of the financing, in which the seller defers part of the purchase price.

For venture-backed companies, which finance themselves through equity capital from investors and still report negative EBITDA, the ratio of net financial debt to EBITDA is not meaningful. Providers of venture debt, that is, of loans designed specifically for such companies, rely instead on runway, investor base, most recently raised funds and recurring revenues. As financial covenants, a minimum liquidity or revenue targets are often agreed here.

Worked example: calculating the static and dynamic debt ratio

A mid-sized technology company reports at the balance sheet date equity of EUR 6.0 million and provisions of EUR 1.5 million. Liabilities to banks amount to EUR 7.0 million, trade payables to EUR 2.5 million, and cash and cash equivalents to EUR 1.0 million. EBITDA for the last twelve months is EUR 2.4 million, operating cash flow EUR 1.5 million.

• Debt capital: 1.5 plus 7.0 plus 2.5 = EUR 11.0 million
• Balance sheet total: 6.0 plus 11.0 = EUR 17.0 million, equity ratio 6.0 / 17.0 = around 35%
• Static debt ratio: 11.0 / 6.0 = around 1.8
• Net financial debt: 7.0 minus 1.0 = EUR 6.0 million
• Dynamic debt ratio: 6.0 / 2.4 = 2.5
• Debt repayment period based on operating cash flow: 6.0 / 1.5 = 4 years
• EBITDA in the following year EUR 1.8 million with unchanged debt: 6.0 / 1.8 = around 3.3

The static value hardly changes as a result of the fall in earnings, because equity and debt capital on the balance sheet remain largely the same. The dynamic debt ratio, by contrast, rises by a third. If an upper limit of, say, 3.0 had been agreed in the loan agreement, there would be a breach of the financial covenant although the company continues to achieve positive EBITDA and has not taken on any additional debt. The limit would already be reached at an EBITDA of 6.0 / 3.0 = EUR 2.0 million, that is, after a decline of one sixth.

Distinctions: debt ratio, equity ratio and leverage effect

• Equity ratio: share of equity in the balance sheet total; arithmetically linked to the static debt ratio.
• Debt service capacity: compares the annual burden of interest and repayment with the available cash flow instead of looking at the stock of debt; the ratio is the debt service coverage ratio.
• Net financial debt: the numerator of the dynamic debt ratio and, in the purchase price calculation, the amount deducted from enterprise value.
• Leverage effect: despite the similar name, not a debt ratio. It describes the effect of debt on return on equity, not the sustainability of the debts.
• Government debt ratio: For countries such as Germany or the USA, the term usually means government debt in relation to economic output (gross domestic product). This macroeconomic figure follows its own rules and is not comparable with corporate ratios.

Common mistakes

• Contract definition not applied. Anyone who calculates the dynamic debt ratio with the EBITDA from the annual financial statements, although the loan agreement permits adjustments or earnings contributions from acquisitions, reports a wrong value.
• Reporting date effects overlooked. Net financial debt fluctuates with working capital; a reporting date with a high level of receivables can worsen the value once.
• No forward-looking calculation. An impending breach is established only with the quarterly report, instead of being identified in planning months earlier and discussed with the lender.
• Debt-like items forgotten. Pension provisions, vendor loans or outstanding purchase price instalments from earlier acquisitions are often treated like financial debt in transactions and increase the value.
• EBITDA ratio in loss-making situations. With negative EBITDA, the ratio cannot be interpreted; a negative multiple is not a low debt ratio.

Frequently asked questions

What is a good debt ratio?

There is no universally valid threshold. For the static debt ratio, classical finance theory gives as a rule of thumb a ratio of debt to equity of at most 1 to 1, in a weaker form 2 to 1 (vertical financing rule). In practice, banks accept higher values depending on the sector. For the dynamic debt ratio, values below 3 are regarded as a rough rule of thumb as comfortably sustainable.

In the end, what counts is whether interest and repayment can be paid out of cash flow even in a weak year. Companies with predictable, recurring revenues can therefore carry more debt than those with fluctuating earnings. An optimal value exists only in the individual case: more debt capital lowers the average cost of capital as long as it is serviced reliably, but increases the risk of default.

How is the debt ratio calculated?

Statically as debt capital divided by equity, dynamically as net financial debt divided by the EBITDA of the last twelve months. In the worked example, 11.0 / 6.0 gives a static value of around 1.8 and 6.0 / 2.4 a dynamic value of 2.5.

Do shareholder loans count as debt?

On the balance sheet yes, in analysis it varies. Banks often count subordinated shareholder loans as economic equity; in the purchase price calculation of a company sale, by contrast, they are regularly deducted as financial liabilities or repaid by the acquirer.

Why do banks calculate with net financial debt rather than gross debt?

Because cash and cash equivalents could be used for repayment at any time. For companies with high liquidity and at the same time high loans, a gross view would be too strict. Some loan agreements, however, limit the amount of cash and cash equivalents that may be counted.

What role does the debt ratio play in a company sale?

A double one. Net financial debt is deducted from enterprise value and reduces the purchase price for the shares. At the same time, the ratio of debt to EBITDA determines how much debt capital an acquirer can raise for the takeover, and thus what price it can finance.

The Roemer Capital view

In his book "Kapital folgt Struktur" (Capital Follows Structure), Lucas Roemer distinguishes between companies that are capital-capable (kapitalfähig) and investor-ready (investorenfähig). A company is capital-capable if it can service loans out of its business. The central yardstick for this is debt service capacity; the debt ratio complements it with a view of the stock of debt. A company is not yet investor-ready on that basis, that is, structurally able to grow disproportionately with external capital. We therefore clarify early whether a capital requirement should be covered with debt, with equity or with a combination.

Where loans exist or are added, we map the contractual financial covenants in the financial model. For the base case, the conservative case and the optimistic case, we show how much headroom remains to the respective upper limit. That way an impending breach becomes visible before it appears in a report to the bank.