The debt ratio compares a company's total debt to its total assets, which is used to gain a general idea as to the amount of leverage being used by a company. A low percentage means that the company is less dependent on leverage, i.e., money borrowed from and/or owed to others. The lower the percentage, the less leverage a company is using and the stronger its equity position. In general, the higher the ratio, the more risk that company is considered to have taken on.
As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had total liabilities of $1,036.80 (balance sheet) and total assets of $5,721.90 (balance sheet). By dividing, the equation provides the company with a relatively low percentage of leverage as measured by the debt ratio.
The easy-to-calculate debt ratio is helpful to investors looking for a quick take on a company's leverage. The debt ratio gives users a quick measure of the amount of debt that the company has on its balance sheets compared to its assets. The more debt compared to assets a company has, which is signaled by a high debt ratio, the more leveraged it is and the riskier it is considered to be. Generally, large, well-established companies can push the liability component of their balance sheet structure to higher percentages without getting into trouble.
However, one thing to note with this ratio: it isn't a pure measure of a company's debt (or indebtedness), as it also includes operational liabilities, such as accounts payable and taxes payable. Companies use these operational liabilities as going concerns to fund the day-to-day operations of the business and aren't really "debts" in the leverage sense of this ratio. Basically, even if you took the same company and had one version with zero financial debt and another version with substantial financial debt, these operational liabilities would still be there, which in some sense can muddle this ratio.
For example, IBM and Merck, both large, blue-chip companies, which are components of the Dow Jones Index, have debt ratios (FY 2005) of 69% and 60%, respectively. In contrast, Eagle Materials, a small construction supply company, has a debt ratio (FY 2006) of 48%; Lincoln Electric, a small supplier of welding equipment and products, runs a debt ratio (FY 2005) in the range of 44%. Obviously, Zimmer Holdings' debt ratio of 18% is very much on the low side.
The use of leverage, as displayed by the debt ratio, can be a double-edged sword for companies. If the company manages to generate returns above their cost of capital, investors will benefit. However, with the added risk of the debt on its books, a company can be easily hurt by this leverage if it is unable to generate returns above the cost of capital. Basically, any gains or losses are magnified by the use of leverage in the company's capital structure.
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