What is the Debt Ratio?
Definition: Debt ratio is a financial measure that helps in determining whether the company has loans or not and if it does how the total liabilities compare to its assets. In simple terms, this solvency ratio shows the ability of the company to pay off debt using its assets. The ratio indicates how many assets a company has to sell for it to meet its debt obligations.
This is total combination of the company’s equity and debts as a measure of the company’s financial leverage. If a company has more liabilities relative to assets then it is highly leveraged meaning that it poses a risk for lenders as it will not be able to pay off its debts. On the other hand, if the company’s equity percentage is higher it is thus in a better position of managing risk and it can meet its asset requirements as well as avoid insolvency.
This is among the many ratios that creditors and investors use to assess the amount of leverage the company will use to enhance its assets or capital with the aim of making profits. The debt ratio describes the financial health of the company and it is determined for the financial statements of the company.
Debt Ratio Formula
To calculate debt ratio formula you need total assets and debt (liabilities) both of which you can obtain from the balance sheet. You then have to divide total liabilities/debt by the total assets.
Here is what the debt ratio equation looks like:
The total liabilities should include both long-term and near-term obligations. You can calculate total debts by getting the difference between total assets and equity.
Debt Ratio Example Analysis
For most companies, a lower debt ratio of below 0.4 is preferable since the company has to pay debt interest regardless of its profitability. A lot of debt can put the company’s operations in jeopardy if its cash flow declines. When a company cannot services its debt it may be pushed into selling its assets or declaring insolvency.
Companies with debt ratio of more than 0.6 find it hard to borrow cash because most lenders have established ratio limits. As a result, they are less likely to extend credit to over leveraged companies. The high ratio means the company is deploying more debts relative to equity which implies most of its assets are from on loan capital. For such companies they believe is that if they take more risks they could create extra income and thus enhance profitability. But conventionally a company should not take unnecessary or take a lot of debts.
However, companies that are using less debt are safe because they are using a conservative approach in the business. As a result, they can attract more investors because the risks in the business are manageable. At the same time lenders are more likely to extend credit because chances of them paying are high.
Debt ratio is an important measure that shows how dependent on debt the company is. Sometimes a company can consider leverage as a way of boosting earnings through loans but this can be risky. Interestingly debt ratio of a company depends on the sector or industry where it operates. For instance tech companies are considered to have unpredictable cash flows and thus their debt ratio tends to be lower. On the other hand, companies whose cash flows are less volatile have a high debt ratio.
Having a low debt ratio protects companies should lenders decide to increase interest. But a particularly low ratio is not a guarantee that the company is running its operations well. It can be due to the lack of liquidity that is hindering the company from growing the way it should.
Summary
Therefore debt ratio is an important metric since it shows the amount of leverage the business employs to boost its assets through debt. A low ratio is favorable as it offers the company financial protection.