Understanding the Debt Ratio: Definition and Formula (2024)

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The debt ratio is a financial metric that compares a business’ total debt to total assets. It’s a crucial ratio that analysts and finance professionals use to assess a company’s financial health. In this article, we’ll review the debt ratio and why it is an essential concept for students interested in corporate finance.

What Is the Debt Ratio?

The debt ratio shows how leveraged a company is. It provides insights into the proportion of a company’s financing derived from debt compared to assets. There are variants of this ratio that consider liabilities to equity. However, all leverage ratios measure how much a company relies on borrowed funds versus its own funds on some level.

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How to Calculate the Debt Ratio

Mathematically, the debt ratio is calculated by dividing a company’s total debt by total assets and multiplying the result by 100 to express it as a percentage. The formula is as follows:

(Total debt / Total assets) x 100

For instance, if a company has $500,000 in total debt and $1,000,000 in total assets, the debt ratio would be 50%:

(500,000 / 1,000,000) x 100 = 50%

You can skip the multiplication at the end and express the ratio as a decimal. For instance, in this example, the debt ratio would be 0.5.

Interpreting the Debt Ratio

The debt ratio is valuable for evaluating a company’s financial structure and risk profile. 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.

However, what constitutes a “good debt ratio” can vary depending on industry norms, business objectives, and economic conditions. For instance, startups or companies in rapid expansion phases, too, may have higher ratios as they utilize debt to fund growth initiatives. While a higher ratio can be acceptable, carefully analyzing the company’s ability to generate sufficient cash flows to service the debt is essential.

A good debt ratio should align with the company’s financial goals, risk tolerance, and industry standards. It should support the company’s ability to meet its financial obligations, maintain financial stability, and enable sustainable growth. Comparing a company’s ratio to industry peers, historical performance, and industry averages can provide valuable insights to determine what is considered favorable within a specific sector.

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Who Uses the Debt Ratio?

This fundamental financial metric is used by various stakeholders in corporate finance, including:

  • Financial analysts: Financial analysts play a crucial role in assessing a company’s financial performance and making investment recommendations. They rely on this metric to evaluate a company’s risk profile and financial stability. By analyzing the debt ratio, analysts gain insights into the level of financial leverage and the potential impact of debt on the company’s profitability and solvency.
  • Investors: Investors, including individual investors, institutional investors, and fund managers, closely examine the debt ratio when making investment decisions. A company with a favorable ratio may be financially sound and capable of generating consistent returns. Conversely, a high ratio might raise concerns about a company’s ability to manage its debt and fulfill its financial obligations. Investors consider the debt ratio as part of their overall risk assessment and investment strategy.
  • Lenders and creditors: Lenders and creditors, such as banks and financial institutions, rely on this metric to evaluate a company’s creditworthiness and determine its borrowing capacity. A lower ratio indicates a company is at a lower risk of defaulting on its loans and may be more likely to secure favorable financing terms. Lenders use this metric as one of the critical factors in assessing the company’s ability to service its debt and make timely interest and principal payments.
  • Management and executives: This metric is vital for management and executives in making informed financial decisions. It assists in determining the optimal capital structure for the company, balancing the use of debt and equity financing. By monitoring changes in this ratio, management can assess the impact of financing decisions on the company’s risk profile, profitability, and long-term sustainability.
  • Regulatory bodies like the U.S. Securities and Exchange Commission (SEC) may require companies to disclose thia metric as part of their financial reporting obligations. Credit rating agencies also use it as one of the factors in assessing a company’s credit rating. A higher ratio might lead to a lower credit rating, affecting the company’s ability to secure financing at favorable terms.

>>MORE: Is Finance a Good Career Path?

Showcasing You Understand the Debt Ratio on Your Resume

You can convey that you understand this calculation by including any of the following items on your resume:

  • In your skills section: Include “financial ratio analysis,” “debt ratio evaluation,” or “capital structure assessment” as skills to demonstrate your familiarity with financial metrics and your ability to analyze and interpret financial data.
  • Mention coursework: Highlight courses that cover financial analysis, financial management, or corporate finance, as these subjects typically delve into this and similar calculations.
  • Highlight work experience: Describe specific projects or responsibilities that assessed a company’s capital structure or financial health.

Other necessary calculations to master if you’re interested in this career path include the following:

  • Other leverage ratios, including the debt-to-equity (DE) ratio, the debt-to-capital ratio, and the asset-to-equity ratio.
  • The current ratio, which compares a company’s current assets to its current liabilities.
  • Quick ratio, which measures a company’s short-term liquidity against its short-term obligations.
  • P/E (price-to-earnings) ratio, which compares a company’s share price to its annual net profits.

Learn these and other in-demand skills today with Forage’s free job simulations.

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Understanding the Debt Ratio: Definition and Formula (1)

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Understanding the Debt Ratio: Definition and Formula (2024)

FAQs

What is the formula for debt ratio? ›

A company's debt ratio can be calculated by dividing total debt by total assets. A debt ratio that's less than 1 or 100% is considered ideal, while a debt ratio that's greater than 1 or 100% means a company has more debt than assets.

How do you interpret the debt ratio? ›

Interpreting the 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.

How to calculate debt to ratio? ›

How do I calculate my debt-to-income ratio? To calculate your DTI, you add up all your monthly debt payments and divide them by your gross monthly income. Your gross monthly income is generally the amount of money you have earned before your taxes and other deductions are taken out.

What is the debt to asset ratio for dummies? ›

The debt ratio, or total debt-to-total assets, is calculated by dividing a company's total debt by its total assets. It is also called the debt-to-assets ratio. It is a leverage ratio that defines how much debt a company carries compared to the value of the assets it owns.

What is the simple formula for debt equity ratio? ›

The formula for calculating the debt-to-equity ratio is to take a company's total liabilities and divide them by its total shareholders' equity.

What is the formula for ratio? ›

Ratios compare two numbers, usually by dividing them. If you are comparing one data point (A) to another data point (B), your formula would be A/B. This means you are dividing information A by information B. For example, if A is five and B is 10, your ratio will be 5/10.

What's a good 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.

What is the best explanation of debt-to-income ratio? ›

How to calculate your debt-to-income ratio. Your debt-to-income ratio (DTI) compares how much you owe each month to how much you earn. Specifically, it's the percentage of your gross monthly income (before taxes) that goes towards payments for rent, mortgage, credit cards, or other debt.

How to calculate total debt? ›

You collect all your long-term debts and add their balances together. You then collect all your short-term debts and add them together too. Finally, you add together the total long-term and short-term debts to get your total debt. So, the total debt formula is: Long-term debts + short-term debts.

How do you fix debt to ratio? ›

Paying down debt is the most straightforward way to reduce your DTI. The fewer debts you owe, the lower your debt-to-income ratio will be. Suppose that you have a car loan with a monthly payment of $500. You can begin paying an extra $250 toward the principal each month to pay off the vehicle sooner.

How do you calculate debt worth ratio? ›

3. How do you calculate debt to net worth ratio? The debt to net worth ratio can be calculated by dividing total liabilities by net worth.

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).

How do you interpret the total debt ratio? ›

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 a healthy asset to debt ratio? ›

From a pure risk perspective, debt ratios of 0.4 or lower are considered better, while a debt ratio of 0.6 or higher makes it more difficult to borrow money. While a low debt ratio suggests greater creditworthiness, there is also risk associated with a company carrying too little debt.

How to interpret debt-to-equity ratio? ›

A high debt-to-equity ratio indicates that a company is borrowing more capital from the market to fund its operations, while a low debt-to-equity ratio means that the company is utilizing its assets and borrowing less money from the market. Capital industries generally have a higher debt-to-equity ratio.

What is the formula for debtors ratio? ›

How to Calculate the Debtors Turnover Ratio. The formula to determine this ratio is fairly straightforward: Divide net credit sales by the average accounts receivable. The resulting figure showcases how often a company has collected its average accounts receivable within a set timeframe.

What is the formula for debt limit ratio? ›

What Is the Debt-to-Limit Ratio? The debt-to-limit ratio is a metric used to assess the creditworthiness of a borrower. It is calculated by dividing the borrower's total outstanding revolving debt (such as on their credit cards) by the total amount of credit available to them.

What is the formula for debt to worth ratio? ›

The debt to net worth ratio is obtained by dividing the total liabilities by the net worth. The total liabilities is the sum of all the monies owed to creditors. The net worth is the difference between the sum of all assets and the liabilities.

What is the formula for debt collection ratio? ›

If a company gives one month's credit then, on average, it should collect its debts within 45 days. The debtor collection period ratio is calculated by dividing the amount owed by trade debtors by the annual sales on credit and multiplying by 365.

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