Borrowing Ratio Calculation (with Example)

The borrowing ratio, also known as the debt-to-equity ratio or leverage ratio, is a financial metric that measures the proportion of a company’s total debt in relation to its long-term capital, which typically consists of shareholders’ equity or net worth. This ratio is crucial in assessing the financial structure of a company, specifically how much of its capital is financed through debt rather than through the shareholders' equity. The borrowing ratio offers insight into a company’s risk level, financial stability, and the degree to which it relies on debt to fund its operations and growth.

At its core, the borrowing ratio shows the relationship between a company’s debt and its net worth. A higher borrowing ratio indicates that the company is more reliant on debt financing to fund its activities, while a lower borrowing ratio suggests that the company uses more equity to finance its operations. While debt can be an effective tool for fueling growth, an excessive reliance on borrowing introduces risks that could compromise a company's financial health.

When a company takes on debt, it incurs an obligation to make regular interest payments and, eventually, to repay the principal amount. These debt obligations can place a strain on a company’s cash flow, particularly if the company is unable to generate enough revenue to cover its interest payments. As a result, a high borrowing ratio means that a larger portion of the company’s profits will be used to service the debt, which leaves less capital for reinvestment or for distributing dividends to equity shareholders. This can lead to reduced profitability and, in some cases, lower returns for shareholders. Furthermore, companies with higher borrowing ratios are often seen as riskier investments because of their dependence on debt and the potential challenges they face in meeting their financial obligations.

One of the main concerns associated with a high borrowing ratio is the company’s ability to meet its debt obligations during periods of financial difficulty or economic downturns. Companies that are heavily reliant on debt financing may struggle to maintain their operations or survive when sales decline or when they experience a significant drop in cash flow. This is particularly risky for companies with variable income or in industries subject to cyclical fluctuations. In such cases, companies with high borrowing ratios may face difficulties in servicing their debt, which could lead to defaults, bankruptcy, or financial restructuring. Therefore, investors and analysts pay close attention to borrowing ratios as an indicator of financial risk, as it helps them assess the company's ability to weather periods of financial hardship.

On the other hand, a low borrowing ratio suggests that the company is not overly reliant on debt to finance its activities, and its equity holders provide a significant portion of the capital. This can be seen as a sign of financial stability and lower risk, as the company is less burdened by debt-related obligations and is better positioned to weather economic downturns. A low borrowing ratio may also indicate that the company is more conservative in its approach to financing and may be less likely to take on excessive debt. For conservative investors or stakeholders looking for more secure investments, a company with a low borrowing ratio may be more attractive because of the perception of lower financial risk.

However, it’s important to note that the borrowing ratio is not inherently good or bad. Rather, it is a reflection of the company’s strategy and the industry in which it operates. For example, some industries are more capital-intensive than others and naturally require higher levels of borrowing to finance their operations. For instance, utility companies, infrastructure firms, and large manufacturing corporations often have higher borrowing ratios because their operations require significant capital investment in fixed assets, such as plants, machinery, and infrastructure. In these industries, borrowing is often necessary for growth and expansion, and a higher borrowing ratio is not necessarily a negative indicator.

In contrast, industries that are less capital-intensive, such as software companies or service-based firms, may have lower borrowing ratios since their business models do not require substantial investments in physical assets. In these sectors, companies may rely more on equity financing or internal cash flow to fund their operations and growth. For such companies, a higher borrowing ratio could indicate that they are taking on more risk than is typical or necessary for their operations.

Furthermore, the borrowing ratio must be analyzed in the context of the company’s overall financial health, profitability, and ability to generate cash flow. A company with a high borrowing ratio but strong cash flow, profitability, and a solid credit history may be able to handle its debt more effectively than a company with a low borrowing ratio but weak financial performance. Conversely, a company with a low borrowing ratio but poor financial performance may still face significant risk, as it may struggle to generate sufficient revenue to fund its operations without resorting to debt financing in the future.

To understand the implications of the borrowing ratio, it is also necessary to look at the company’s industry benchmarks and historical trends. Comparing a company’s borrowing ratio to the average for its industry can provide valuable context in assessing whether its debt levels are in line with industry norms. For example, if a company’s borrowing ratio is significantly higher than its industry peers, it may be a signal of excessive debt and higher risk. On the other hand, if the borrowing ratio is lower than the industry average, it could indicate that the company is more conservative in its financing strategy or that it has a stronger balance sheet with less reliance on external debt.

In addition to industry comparisons, it’s also important to consider the borrowing ratio over time. An increasing borrowing ratio may indicate that the company is becoming more reliant on debt, which could signal a potential shift in its financial strategy or a change in its capital structure. This could be a result of the company taking on more debt to fund expansion or acquisitions, or it could indicate a deterioration in its ability to generate equity or raise capital. Conversely, a declining borrowing ratio may suggest that the company is reducing its reliance on debt, possibly by paying down existing debt or by raising additional equity capital.

Despite the insights provided by the borrowing ratio, it is not a standalone metric. It should be used in conjunction with other financial ratios and analysis tools to gain a more comprehensive understanding of a company’s financial position. Ratios such as interest coverage, liquidity ratios, and profitability ratios provide additional context for understanding how well the company is managing its debt obligations and whether it has the financial strength to meet its future commitments.

In conclusion, the borrowing ratio is an important measure of a company’s financial leverage, showing how much of its long-term capital is financed through debt. A high borrowing ratio suggests that the company is highly leveraged, which may increase the financial risk associated with its operations, as more of its profits will be directed towards paying interest on debt rather than being available for reinvestment or distribution to shareholders. Conversely, a low borrowing ratio may indicate a more conservative approach to financing, with less reliance on debt and greater stability. However, the borrowing ratio should be considered in the context of the company’s industry, financial health, and long-term strategy, as well as in comparison to its peers and historical trends. A balanced approach to debt and equity financing is essential for managing risk and ensuring long-term sustainability.

The ratio can be calculate as follows:

Formula:
Borrowing Ratio = Total borrowings / Net worth
Note: Total borrowings include long-term debt, short-term debt and bank overdraft.

Example:
The following information relates to Company XYZ:
Capital at start $150,000
Net profit for the year $110,000
Drawings $10,000
Bank overdraft $20,000
Mortgage loan $200,000

Then,
Total borrowings = Mortgage loan + Bank overdraft = 200,000 + 20,000 = $220,000
Capital at end (Net worth) = Capital at start + Net profit - Drawings = 150,000 + 110,000 - 10,000 = $250,000
Borrowing Ratio = 220,000 / 250,000 = 0.88 (This can be expressed as percentage, i.e., 88% geared)