What is the debt ratio?
Definition: The debt ratio is financial ratio used in accounting to show what portion of a business's assets are financed through debt.
To find the debt ratio for a company, simply divide their total debt by their 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 looks like this:
Debt ratio = Total Debt/Total assets
An example: if a business has $1,000,000 total assets and $300,000 total liabilities, it's debt ratio will be 3/10, or 30%.
What does the debt ratio indicate?
A company's debt ratio of a company offers a view at how the company is financed. The company could be financed by primarily debt, primarily equity, or an equal combination of both.
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). Conversely, if a company has a low debt ratio (below .5 or 50%), this indicates that most of their assets are fully owned (financed through the firm's own equity, not debt).
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.