The debt ratio is a financial ratio that relates to the solvency levels in a company as they assess the debt to asset ratio. The debt ratio shows the company’s ability to pay off liabilities with the use of its assets. That would demonstrate the number of assets the company would have to sell to pay off the liabilities in full.
It illustrates a particular perspective concerning corporate finance, and that indicates the leverage held. The firm may be financed by debt, equity, or even both. It also considers the short and long-term assets by applying both of them within the calculation of the total assets when set against the total debt.
What the Debt Ratio Shows
The debt ratio shows the level of risk which the business has attained. The preferable thing is for a low-risk level, which means a business that is not too reliant on borrowed funds. So it would be financially stable. Businesses that have low ratios, meaning 0.5 and below, show the assets are wholly owned. Companies with high debt ratios; 0.5 and above are termed as highly leveraged.
The higher the amount of debt, the greater the risk related with a company’s operations. A low ratio indicates conventional financing with the ability to borrow in the future with limited risk.
The majority of a company’s assets are financed throughdebt rather than equity. A high debt ratio illustrates the business is in a bad financial state should the creditors decide on repayment of loans. That is the reason why lower ratios are preferred. To attain a good debt ratio, businesses need to compare their position to the industry’s average or the most significant competitors.
Formula
It is illustrated as dividing the liabilities by the total assets
Debt Ratio = Total Liabilities / Total Assets
Example
A startup has been running for six months, and they consult the bank concerning their chances of getting a new loan for expansion. The financial institution asks for the balance, so they evaluate the total levels of debt. It is discovered that the total assets number $124,000 while the liabilities are at $93,000. The debt ratio for the startup would be calculated as
$93,000/$126,000 = 0.75
That means the debt ratio is 0.75, which is highly risky. It indicates for every four assets; there are three liabilities. The startup is highly leveraged, and there is a minimal chance that the bank would award the business the loan based solely on this information. That level of debt can compromise the operation should the cash flow end. The firms that cannot service their debt can have to sell their assets and declare solvency.
Analysis
The debt ratio tends to be in decimal format as it calculates the total liabilities according to a percentage of the total assets. Similarly, as with many solvency related ratios, a lower figure would be favorable than the higher ratios. A low debt ratio means the business is stable, and there is more potential longevity because it has low levels of debt overall. Each sector has different benchmarks for the leverage, but 0.5 has been deemed as the common midpoint.
Since utility companies usually have a lot of company debt on their balance sheets, the debt ratio is useful in determining how many years of EBITDA it would take to pay back all the debt.
Lender Limits
Lenders usually have limits concerning the debt ratio above which they would not extend credit to organizations because they are overleveraged. Obviously, there are other things to consider, including payment history, professional relations, and the business’s credit. The investors, though, may rarely desire to buy company stock when there are very low debt ratios.
Should the debt ratio be at zero, it would mean that the business may not finance a lot of operations through borrowing in the first place. That means it is very risk-averse, and so there is a slow rate of return, which would be realized so the shareholders cannot depend on dividends quickly. Other ratios are better at assessing leverage, such as the debt to equity ratio, because it measures the opportunity costs.
Usually, the larger and stable organizations can push on the ledgers’ liabilities compared to the smaller firms. They also tend to have better and more robust cash flows as they can negotiate with lenders due to the economies of scale involved. The debt ratios also happen to be sensitive to interest rates.
All of the assets with interest rates have risk, whether they are loans or bonds. The same amount is costly to pay regardless of a 5 of 10% interest rate. There is a sense that the ratio analysis has to be done based on company-by-company. Balancing the dual risks of company debt and the opportunity costs is essential for all organizations.
Chris Douthit
Chris Douthit, MBA, CSPO, is a former professional trader for Goldman Sachs and the founder of OptionStrategiesInsider.com. His work, market predictions, and options strategies approach has been featured on NASDAQ, Seeking Alpha, Marketplace, and Hackernoon.
FAQs
The debt ratio shows the level of risk which the business has attained. The preferable thing is for a low-risk level, which means a business that is not too reliant on borrowed funds. So it would be financially stable. Businesses that have low ratios, meaning 0.5 and below, show the assets are wholly owned.
What is the best ratio for debt ratio? ›
Do I need to worry about my debt ratio? If your debt ratio does not exceed 30%, the banks will find it excellent. Your ratio shows that if you manage your daily expenses well, you should be able to pay off your debts without worry or penalty. A debt ratio between 30% and 36% is also considered good.
How can debt ratio be greater than 1? ›
A debt ratio of greater than 1.0 or 100% means a company has more debt than assets while a debt ratio of less than 100% indicates that a company has more assets than debt.
What is the most important debt management ratio? ›
The debt/asset ratio shows the proportion of a company's assets which are financed through debt. If the ratio is less than 0.5, most of the company's assets are financed through equity. If the ratio is greater than 0.5, most of the company's assets are financed through debt.
What is the best equity to debt ratio? ›
Generally, a good debt to equity ratio is around 1 to 1.5. However, the ideal debt to equity ratio will vary depending on the industry, as some industries use more debt financing than others.
Is a debt ratio of 1 good? ›
Generally, a good debt ratio is around 1 to 1.5. However, the ideal debt ratio will vary depending on the industry, as some industries use more debt financing than others. Capital-intensive industries like the financial and manufacturing industries often have higher ratios that can be greater than 2.
Is 75% a good debt ratio? ›
A debt ratio below 0.5 is typically considered good, as it signifies that debt represents less than half of total assets. A debt ratio of 0.75 suggests a relatively high level of financial leverage, with debt constituting 75% of total assets.
What is a healthy debt ratio? ›
It's calculated by dividing your monthly debts by your gross monthly income. Generally, it's a good idea to keep your DTI ratio below 43%, though 35% or less is considered “good.”
What if debt ratio is 1? ›
If a company's debt ratio is 1, it means that the company's total debt is equal to its total assets. Or you could say that if a company wants to repay its debt, it has to sell all its assets. If a company has to pay its debt, it has to sell all its assets, in which case the company can no longer operate.
What is a bad debt ratio? ›
The bad debt to sales ratio represents the fraction of uncollectible accounts receivables in a year compared to total sales. For example, if a company's revenue is $100,000 and it's unable to collect $3,000, the bad debt to sales ratio is (3,000/100,000=0.03).
As of February 2023, the Japanese car manufacturer Toyota was the company with the highest debt worldwide, amounting to 217 billion U.S. dollars. The Chinese property developer Evergrande followed in second with a debt of roughly 170 billion U.S. dollars, with Volkswagen following in third.
Which industry has the highest debt ratio? ›
The Highest Debt-To-Equity Ratios
Borrowed money is a bank's stock in trade. Banks borrow large amounts of money to loan out large amounts of money, and they typically operate with a high degree of financial leverage. D/E ratios higher than 2 are common for financial institutions.
What is the most common debt coverage ratio? ›
Different types of lenders have different requirements for minimum debt service coverage ratio — there is no universal industry standard. That said, a DSCR of 1.25 to 1.50 is a typical minimum for most lenders, while a DSCR of 2.0 would be considered very strong.
What is Apple's debt-to-equity ratio? ›
Apple has a total shareholder equity of $74.1B and total debt of $108.0B, which brings its debt-to-equity ratio to 145.8%. Its total assets and total liabilities are $353.5B and $279.4B respectively. Apple's EBIT is $118.7B making its interest coverage ratio 648.4. It has cash and short-term investments of $73.1B.
What is Google's debt-to-equity ratio? ›
The D/E ratio compares a company's total debt to its equity. A value under 100% is good. As of the end of the 2019 fiscal year, Google's D/E ratio was 0.08, indicating an extremely low debt load compared to its equity. In fact, over the 15-year period from 2005-2020, Google's D/E ratio has never risen above 10%.
How much debt is too much? ›
Most lenders say a DTI of 36% is acceptable, but they want to lend you money, so they're willing to cut some slack. Many financial advisors say a DTI higher than 35% means you have too much debt. Others stretch the boundaries up to the 49% mark.
Is a debt ratio of 50% good? ›
Broadly speaking, ratios of 60% (0.6) or more are considered high, while ratios of 40% (0.4) or less are considered low.
What is a 3 to 1 debt ratio? ›
Example of Debt to Equity Ratio
A corporation with $1,200,000 of liabilities and $2,000,000 of stockholders' equity will have a debt to equity ratio of 0.6:1. A corporation with total liabilities of $1,200,000 and stockholders' equity of $400,000 will have a debt to equity ratio of 3:1.
Is a 7% debt-to-income ratio good? ›
DTI is one factor that can help lenders decide whether you can repay the money you have borrowed or take on more debt. A good debt-to-income ratio is below 43%, and many lenders prefer 36% or below. Learn more about how debt-to-income ratio is calculated and how you can improve yours.
