Debt ratio is a financial solvency ratio that measures the company total liabilities as a percentage of its total assets. In other words, it shows how much of its assets does the company need to sell in order to cover all of its liabilities. It’s a measurement of the financial leverage of the company. As a general principle, companies with higher leverage are considered highly leveraged and more risky to lenders and investors. Other way of looking at the debt ratio is that the higher the debt ratio is the higher is the portion of the company’s assets that are financed with debt. If the ratio is lower that means that more of the company is financed through equity
The formula for total debt ratio calculation is total liabilities divided by total assets:
Debt Ratio = Total Liabilities / Total Assets
Both of these numbers can easily be found the balance sheet.
Based on the formula for calculating the debt ratio. Since the debt ratio is representing the total liabilities as a percentage of total assets, the lower the number is the better he financial health of a company is. A lower debt ratio usually means a more stable business with safer future prospects. Each industry has different average debt ratio depending on the way businesses in the different industry structure and run their operations.
A debt ratio of at least 0.5 is generally considered as solid and less risky. This means that the company liabilities are only half of its assets. Other way of looking at this is that the creditors of the company own about half of the company and the other half belongs to the shareholders. A debt ratio that is larger and closer to 1 means that the company is highly leveraged and might be risky. The more company borrows money the more its debt ratio increase and the more future lenders are going to be hesitant to lend to the company. This will lower the business future financial flexibility.