Debt Ratio

Last Updated :

21 Aug, 2024

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Debt Ratio Meaning

A debt ratio is a tool that helps determine the number of assets a company bought using debt. The ratio helps investors know the risk they will be taking if they invest in an entity having higher debt used for capital building. The ratio also lets them assess how fruitfully a company uses its debt to build and expand its business.

This ratio is derived when the companies' total debt is divided by their total assets. The total assets value considers both the firm's short-term and long-term assets. As a result, the calculation offers a crystal clear view of the finances and financial obligations of the businesses.

Debt Ratio Meaning

A debt ratio helps determine how financially stable a company is with respect to the number of asset-backed debt it has.
It acts as one of the solvency ratios for investors as they can assess the probability of a firm turning bankrupt in the long run based on the debt-to-asset value.
The ratio also helps the top management check their company's performance and make relevant decisions.
A value of less than 1 is considered ideal for any company, while it may vary per the industry for which it is being calculated.

How Does Debt Ratio Work?

The debt ratio plays a vital role in helping assess the financial stability of a firm, given the number of asset-backed debts it possesses. It compares the total debt with respect to the company's total assets and is represented as a decimal value or in the form of a percentage.

The companies generate the required financial statements to present to their stakeholders, including investors, to indicate their financial status clearly. These statements include the balance sheet, cash flow statement, income statement, and statement of shareholder's equity. When the investors go through the financial statements of the companies in question, they analyze their position by computing the total debts with respect to the total assets and then finally find out the ratio.

Given its purpose, the ratio becomes one of the solvency ratios for investors. This is because the value derived helps them understand how likely those entities are to go bankrupt in the event of consecutive defaults.

Formula

The debt ratio formula used for calculation is:

Debt Ratio= Total Debt / Total Assets

Interpretation

When the total debt is more than the total number of assets, it depicts that the company has more liabilities than assets. Thus, this debt-to-asset ratio is expected to be less than 1 for investors to take an interest in investing in it and for creditors to rely on the entity for time repayments and default-free deals. On the other hand, if the value is 1 or more, the investors know that the total amount of debt is too much for the companies to pay back, so they decide not to invest in it.

There are instances where total liabilities are considered the numerator in the formula above. However, liability and debt being two different terms might lead to discrepancies in the values obtained. Whether debt and liabilities could be treated similarly would completely depend on the elements used to calculate the sum of the debts. Liabilities, on the contrary, are better when treated as a numerator for debt ratio with equity as a denominator.

Example

Boom Co. provides for the following details to help investors calculate the debt ratio:

Short-Term Assets – $30,000
Long-Term Assets – $300,000
Total Debt – $110,000

Based on the above information, the first thing would be to calculate total assets:

Total Assets = Short-term Assets + Long-term Assets

= $30,000 + $300,000

= $330,000

The next step is calculating the ratio as the users know the total debt.

Debt Ratio= Total Debt / Total Assets

= 110,000/330,000 = 0.33

Here, the value states that the company has a good debt ratio. Hence, the investors would be fine with investing in it.

Significance

This ratio is useful for two groups of people. The first group is the company’s top management, which is directly responsible for the expansion or contraction of a company. With the help of this ratio, top management sees whether the company has enough resources to pay off its obligations.

The second group is the investors who assess the position of a company before they finally decide to put their money into it. The investors must know whether the firm has enough assets to bear the expenses of debts and other obligations.

The debt-to-asset ratio also measures the financial leverage of the company. And it also tells the investors how leveraged the firm is. For example, if the firm has a higher level of liabilities compared to assets, then the firm has more financial leverage and vice versa.

Debt Ratio Calculator

Here we bring our calculator for users. Put the details in the respective boxes and calculate the ratio instantly.

Frequently Asked Questions (FAQs)

What does the debt ratio mean?

It is the ratio of a company's total debt to its total assets. The ratio represents its ability to hold the debt and be in a position to repay the debt, if necessary, on an urgent basis. Through the debt-to-asset ratio, the investors learn how financially stable a company is. Based on the evaluation, they decide whether it would be beneficial for them to invest in it.

How to calculate the debt ratio?

Users add all company's assets to get the total assets and find the sum of the debt for the total debt they possess. Then, they divide the latter by the former to derive the debt-to-asset ratio. This value helps the company's top management and investors make effective decisions for the company and themselves.

What debt ratio is good?

A ratio of less than 1 is considered ideal as this indicates that the total number of assets is more than the amount of debt a company acquires. When the value is 1 or more, it depicts the tight financial status of the firm. A higher value will mean the entity is more likely to default and may turn bankrupt in the long run.