This is a complete guide on how to calculate Debt Ratio with detailed interpretation, analysis, and example. You will learn how to use its formula to assess a company's debt repayment capacity.
What is Debt Ratio?
The debt ratio allows you to calculate what portion of a company’s assets has been financed by debt.
The value of this ratio will provide you with information about the solvency of a particular business, and how capable it is of meeting its long-term financial obligations.
Generally speaking, the higher a firm’s debt ratio value, the riskier its financial structure, since the majority of its assets will have been paid for with borrowed funds.
There’s always the risk that a company in this situation will eventually find itself unable to service its debt load.
The closer the ratio value is to 0%, the more stable and economically conservative a company is, with a greater portion of its assets having been purchased with investor equity.
Total Debt Ratio Formula
So how do you calculate debt ratio?
To compute the debt ratio value for a business you may wish to invest in, you would use the following formula:
Debt Ratio = Total Liabilities / Total Assets
Because this ratio is a measure of solvency, it considers all of a company’s liabilities, not just its current amount of debt.
Debt Ratio Calculator
Example - How To Calculate Debt Ratio
So now you know the formula for debt ratio, let's have a look at the following example to learn how to find this ratio in real life.
Company Q operates in a highly changeable and competitive industry. As a result, its revenues and cash flow have a tendency to fluctuate and are relatively unpredictable.
Because you’re considering buying stock in Company Q, you’d like to get a better picture of its solvency situation.
Company Q’s balance sheet provides the following information:
- Total Assets = $4,000,000
- Total Liabilities = $1,000,000
The debt ratio equation looks like this:
From this result, you can see that Company Q has a relatively low debt ratio value, where only ¼ of its total assets are funded by debt.
A lower ratio value is far more desirable for a volatile business like Company Q.
Debt Ratio Analysis
The value of an acceptable debt ratio varies widely between companies and industries, and the results of your calculations should be considered alongside other financial factors.
So what is a good debt ratio?
Although a lower ratio value is considered more ideal, since it’s associated with less financial risk, a higher value may be quite acceptable for a business that benefits from a consistent and reliable income stream.
Quite often in niche industries, or other situations where there is little competition, a business can take on higher levels of debt with fewer monetary repercussions.
This debt can be used to increase the level of return on investment for shareholders, or to fund the expansion of business operations.
There’s also the added bonus that loan interest can often be deducted as an expense, providing the company with an important tax advantage.
At the same time however, it’s important to keep in mind that the more debt a company carries, the more susceptible it becomes to the effects of rising interest rates, and the less money it may have available to support its own business growth.
Cautions When Using The Total Debt Ratio
You should recognize that not all debt is bad.
Most companies need to use a certain level of credit in order to operate effectively, and it would simply be unfair and unrealistic to label all of a firm’s liabilities as negative.
Because the debt ratio lumps all debt together, it doesn’t distinguish between which liabilities will be paid off in the short-term, and which will be carried for the long haul.
Some types of asset-heavy businesses traditionally display a higher ratio, since their large asset value gives them a larger borrowing base.
The very general debt picture provided by this ratio, along with the fact that asset depreciation isn’t taken into account, can often skew the information you take away from the ratio value.