Debt Ratio Explained

Debt Ratio Explained What is the Debt Ratio?

The Debt Ratio is a financial ratio that indicates the percentage of a company’s or individual’s assets that are provided through debt; in essence the debt ratio is a ratio of total debt (the sum of all current liabilities plus long-term liabilities) and the total amount of assets in possession (the sum of current assets and fixed assets).

For example, if a company possesses $4 million in total assets and $600,000 in total liabilities, the company would have a debt ratio of 15%. This number signifies a great deal of information; the debt ratio is a fundamental calculation used to observe a company’s riskiness or long-term positioning. The higher the debt ratio, the greater risk will be associated with the company’s operation. 

Furthermore, a high debt to asset ratio, will in most cases, indicate a low borrowing capacity, which in turn, will lower the firm’s financial flexibility. Similar to all ratios in finance, a company’s debt ratio should be evaluated and compared with similar organizations or business models in the industry. Evaluating a company’s debt ratio without observing those debt ratios of their competitors would prove pointless.

What does the Debt Ratio tell us?

In summation, the debt ratio will reveal the company’s total liabilities divided by their assets under management. This calculation will reveal the proportion of a company’s assets which are primarily financed through a debt obligation; if the ratio is less than 0.5, the majority of the company’s are financed through equity or cash. If the ratio is larger than .5, the majority of the company’s assets are financed through debt. 

The latter calculation will reveal vulnerability within the company; if the organization fails to generate a substantial profit a significant strain would be realized in regards to the obtainment and proper management of their assets. Those companies who possess high debt to asset ratios are evaluated and observed as “highly leveraged” organizations. 

This characteristic signifies limited liquidity (the presence of cash) and a speculative organization in regards to long-term sustainability (assuming profits are marginal) and investment. A company that is highly leveraged could also be in danger if creditors start to demand repayment of debts. 

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