Dynamic debt ratio: benchmark, calculation & definition

An important business ratio in the assessment of companies is the dynamic debt ratio. It shows how quickly the company's debts could be repaid from its own resources. Here, it is not just the amount of liabilities or their ratio to another balance sheet item that is being considered. With the calculation of the dynamic debt-equity ratio you get a temporal statement – therefore the term "dynamic" is also used. In this article, you will learn how to calculate this ratio and find out which benchmark characterizes a healthy company.

The dynamic debt-equity ratio briefly explained

When evaluating a company and assessing its financial strength and crisis resistance, debt is also regularly considered. The debt-equity ratio – i.E., the ratio of borrowed capital to equity – plays an important role in the calculation. But it actually only becomes interesting for investors when calculating how long the company needs to repay its debt from its own funds. This assumes that the cash flow – i.E. The total "free" liquid funds – is used in full over the following months to repay the liabilities. The ratio then determined is called the dynamic debt-equity ratio. Sometimes you will also find the term debt service capability or debt repayment period in the literature.

This is how the dynamic gearing ratio is calculated

The starting point for the calculation of this ratio is a company's balance sheet and cash flow statement. Both items are required in the annual financial statements of all large and medium-sized companies and sole proprietorships. This formula helps you with the calculation:

The calculation variables debt and cash flow

Borrowed capital includes these items on the balance sheet:

• Provisions
• All liabilities, i.E. Both trade payables and payables to credit institutions and other investors
• Prepaid expenses and deferred taxes

The amount of cash flow is not identical with the profit from operating activities. Only all cash-relevant transactions are considered here; all transactions that do not result in a cash flow are not taken into account. In this way, it is determined which liquid funds are actually available, for example, to make further investments or to repay debts. If the cash flow is not visible from the financial statements (not all companies are required to prepare the cash flow statement), this ratio can be determined indirectly using the income statement:

+ non-cash expenses such as depreciation and amortization, inventory reductions of finished goods and work in progress, the formation of accruals or of reserves

– non-cash income such as write-ups, increases in inventories, reversals of provisions and withdrawals from reserves

The time factor

First, the ratio of debt capital to cash flow is calculated; multiplication by 100 percent reveals the time factor. If the calculation is based on the annual cash flow, 100 percent also refers to the period of one year. When calculating the dynamic debt-equity ratio, it is assumed that the cash flow can also be generated in this amount in subsequent years. This assumes a constant course of business, even without further investment or additional borrowing.

rucodex.orgs for the calculation of the dynamic debt-equity ratio

1. The balance sheet of a company shows debt capital of 20 million euros, the
cash flow for the year was 5 million euros.

The dynamic debt-equity ratio is then calculated:
20 million. € / 5 million. € * 100 % = 400 %

The company could therefore pay off all its debt within the next 4 years if all its cash flow were used to do so.

2. In a smaller company, you will not find a cash flow statement in the balance sheet. You need to figure out this metric from the income statement. You might find these figures in the financial statements:

Net income 500 T€
inventory reductions + 100 T€
depreciation + 150 T€
release of provisions – 10 T€
= cash flow 740 T€

The dynamic gearing ratio: 2.500 K€ / 740 K€ * 100 % = 338 %

Using the entire cash flow, the company would need a little more than 3 years for debt repayment.

Dynamic debt-equity ratio – benchmark and meaningfulness

The financial strength of a company plays an important role for credit institutions and private investors. The dynamic debt-equity ratio is the benchmark for internal financing and shows how quickly the company could pay off its liabilities under its own steam. This ratio will therefore always play a role in the assessment of liquidity. The lower the calculated dynamic debt-equity ratio, the more liquid the company is. It can react very flexibly when the economic fundamentals change. Cash flow is high enough to take out more loans and service additional interest. The business is stably financed.

These guideline values apply to the dynamic gearing ratio:

100 % – 300 %: very good
301 % – 500 %: good
501 % – 1.100 %: average
over 1.100 %: poor

However, one value alone should not be the basis for decision-making when assessing a company. Cash flow may have been influenced by one-off events. It is therefore worthwhile also determining the dynamic debt-equity ratio on the basis of the previous year's balance sheets and comparing the values. If you then look at the development of this ratio, the statements on the company's ability to service its debt become more precise. A sector comparison is also important. In asset-intensive companies, such as in mechanical and plant engineering or also in the construction industry, loans must be taken out in considerable amounts in order to realize sales. A higher debt-equity ratio is much more important for a long-term successful business than in a commercial enterprise.

As an entrepreneur, you can influence the dynamic debt ratio

You have to make entrepreneurial decisions in your daily business so that your balance sheet figures are correct. The aim here is to find a healthy ratio between cash and debt. In the current low-interest phase, high cash reserves are of little use if they are offset by high debts with corresponding interest rates. A too low or even a negative cash flow over a longer period of time proves too high expenses with too low revenues – this endangers the existence and is a reason for the insolvency of the company. Taking on no debt at all is also not a good idea – here you give away the opportunity to generate a higher return on equity with the help of interest on borrowed capital (i.E., to use the leverage effect).

In terms of balance sheet policy, you can take various measures to influence the dynamic leverage ratio:

• Use a too high cash balance for the repayment of liabilities. This also includes, for example, the rapid payment of supplier invoices or the repayment of overdraft facilities utilized.
• Increase your cash flow through cost-cutting measures. Lower loans also mean lower interest, an optimized purchasing policy reduces storage costs.
• Reduce your inventories of finished goods and work in progress and increase cash flow.

In all these considerations, you must always keep the totality of your business in mind. With the strategies for optimizing the dynamic leverage ratio, you can influence various balance sheet items, including net income. The starting point must therefore always be a comprehensive balance sheet analysis, the results of which are various business ratios. When assessing the financial strength and future viability of a company, the dynamic debt/equity ratio and cash flow are as important as various liquidity ratios and other key figures.