The debt ratio is a financial ratio used in accounting to determine what portion of a business's assets are financed through debt.
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A company's debt ratio offers a view at how the company is financed. This provides a clear indication of the amount of leverage held by a business. The company could be financed by primarily debt, primarily equity, or an equal combination of both.
The debt ratio takes into account both short-term and long-term assets by applying both in the calculation of the total assets when compared with total debt owed by the company.
What does the debt ratio indicate?
The debt ratio of a business is used in order to determine how much risk that company has acquired.
A low level of risk is preferable, and is linked to a more independent business that does not need to rely heavily on borrowed funds, and is therefore more financially stable. These businesses will have a low debt ratio (below .5 or 50%), indicating that most of their assets are fully owned (financed through the firm's own equity, not debt).
A high risk level, with a high debt ratio, means that the business has taken on a large amount of risk. If a company has a high debt ratio (above .5 or 50%) then it is often considered to be"highly leveraged" (which means that most of its assets are financed through debt, not equity).
In some instances, a high debt ratio indicates that a business could be in danger if their creditors were to suddenly insist on the repayment of their loans. This is one reason why a lower debt ratio is usually preferable. To find a comfortable debt ratio, companies should compare themselves to their industry average or direct competitors.
How to use the debt ratio
To find the debt ratio for a company, simply divide the total debt by the total assets. Total debt includes a company's short and long-term liabilities (i.e. lines of credit, bank loans, and so on), while total assets include current, fixed and intangible assets (i.e. property, equipment, goodwill, etc.).
The debt ratio:
Debt ratio = Total Debt/Total assets
For example:
- John’s Company currently has £200,000 total assets and £45,000 total liabilities.
- The debt ratio for his company would therefore be: 45,000/200,000.
- The resulting debt ratio in this case is: 4.5/20 or 22%.
- This is considered a low debt ratio, indicating that John’s Company is low risk.
Debt ratio and Debitoor
The easiest way to determine your company’s debt ratio is to be diligent about keeping thorough records of your business finances. This means registering your expenses, staying on top of any loans taken out, and tracking assets and depreciation.
Debitoor accounting and invoicing software gives you the tools to run your business from anywhere, at any time with access from one account across all of your devices.
FAQs
By calculating the ratio between your income and your debts, you get your “debt ratio.” This is something the banks are very interested in. A debt ratio below 30% is excellent. Above 40% is critical. Lenders could deny you a loan.
What is a good debt ratio ratio? ›
35% or less: Looking Good - Relative to your income, your debt is at a manageable level. You most likely have money left over for saving or spending after you've paid your bills. Lenders generally view a lower DTI as favorable.
What does a debt ratio of 0.5 mean? ›
A debt ratio of 0.5 means that a company has half of its assets financed by debt. A debt ratio of 1 means that a company's total debt is equal to its total assets.
Which is the debt ratio? ›
The debt ratio is defined as the ratio of total debt to total assets, expressed as a decimal or percentage. It can be interpreted as the proportion of a company's assets that are financed by debt.
What is the debt ratio quizlet? ›
The debt ratio indicates the percentage of the total asset amounts stated on the balance sheet that is owed to creditors. A high debt ratio indicates that a corporation has a high level of financial leverage.
What is the best debt ratio range? ›
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 0.5 a good debt ratio? ›
If the ratio is over 1, a company has more debt than assets. If the ratio is below 1, the company has more assets than debt. Broadly speaking, ratios of 60% (0.6) or more are considered high, while ratios of 40% (0.4) or less are considered low.
What does a debt ratio of 0.75 mean? ›
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/$126,000 = 0.75. That means the debt ratio is 0.75, which is highly risky. It indicates for every four assets; there are three liabilities.
Is 0.2 a good debt ratio? ›
Low debt ratio: If the result is a small number (like 0.2 or 20%), it means the company doesn't owe a lot compared to what it owns. This is usually a good sign. A lower debt ratio indicates a healthier financial position.
Is 0.1 a good debt ratio? ›
The bank has determined that your business has total assets of 50,000$ and total liabilities of 5,000$. Divide 5,000$ by 50,000$ to calculate the debt ratio. This results in a debt ratio of 0.1. This is a very cheap and low-risk debt ratio.
What Is the Bad Debt to Sales Ratio? This ratio measures the amount of money a company has to write off as a bad debt expense compared to its net sales. In other words, it tells you what percentage of sales profit a company loses to unpaid invoices.
What is a too high debt ratio? ›
Key takeaways
Debt-to-income ratio is your monthly debt obligations compared to your gross monthly income (before taxes), expressed as a percentage. A good debt-to-income ratio is less than or equal to 36%. Any debt-to-income ratio above 43% is considered to be too much debt.
What is a good debt? ›
Good debt is generally considered any debt that may help you increase your net worth or generate future income.
Is a 10% debt ratio good? ›
By calculating the ratio between your income and your debts, you get your “debt ratio.” This is something the banks are very interested in. A debt ratio below 30% is excellent. Above 40% is critical. Lenders could deny you a loan.
Is a debt ratio of 50% good? ›
A good debt ratio is usually below 0.50 or 50% This means the company's assets are mainly funded by equity instead of debt. However you should research the industry average to get a full picture. What is debt ratio analysis? Debt ratio analysis is used to review whether or not a company is solvent long-term.
Is 20% a good debt ratio? ›
Your debt-to-income (DTI) ratio is how much money you earn versus what you spend. 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.”
