Debt Ratio: Formula and How to Calculate
Updated September 24, 2023
If you own a business, it's important to calculate and analyze the amount of money your company owes in relation to its total assets. In essence, your debt ratio allows you to determine whether or not your company will be able to pay off its liabilities with its assets. Determining your debt ratio is especially important if you're hoping to catch the attention of lenders or investors because many prefer to work with companies that have lower levels of liabilities.
In this article, we define debt ratio, list examples and outline how to calculate it for your business.
A debt ratio helps to determine how financially stable a company is and is expressed as the ratio of total debt to total assets.
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.
What is debt ratio?
Debt ratio is the proportion of a company's total debt to its total assets and measures the extent of a company’s leverage. A company’s total debt and total assets can be found on its balance sheet.
The ratio represents its ability to hold the debt and be in a position to repay the debt, if necessary, on an urgent basis. Through the debt-to-asset ratio, the investors learn how financially stable a company is. Based on the evaluation, they decide whether it would be beneficial for them to invest in it.
A high debt ratio, or a ratio greater than 1, indicates that your company has more debt than assets and is at financial risk. This could mean your company won't be able to pay back its loans, debts and other financial obligations.
A low debt ratio, or a ratio below 1, means your company has more assets than liabilities. In other words, your company's assets are funded by equity instead of loans.
A ratio of 1 indicates that the value of your company’s assets and your liabilities are equal. This means that if a company has to pay its debt, it would have to sell all of its assets.
Leverage and risk
Debt > Assets
Debt = Assets
Debt < Assets
Deb << Assets
Tip: The higher the debt ratio, the more leveraged a company is, implying greater financial risk. It’s important to note that leverage is an important tool that companies use to grow, and many businesses find sustainable uses for debt.
Debt ratio formula
Debt ratio is expressed as a decimal or percentage. The formula for debt ratio is:
Debt ratio = Total debt / Total assets
Total liabilities are the total debt and financial obligations payable by the company to organizations or individuals at any defined period of time. Total liabilities are stated on the balance sheet by the company.
Total assets are the total amount of assets owned by an entity or an individual. Assets are items of monetary value, which are used over time to produce a benefit for the asset’s holder.
Example: Let’s say you own a bakery and you’ve calculated that its total assets equal $50,000 and its total debt is $20,000.
Debt ratio = $20,000 / $50,000
Debt ratio = 0.40 or 40%
A low debt ratio of 0.4 means your company is in good standing and is likely able to pay back any accumulated debt.
How to calculate debt ratio
Calculating your company's debt ratio is an important step in determining whether or not your business faces financial risk. As you make your calculations, refer to your company's balance sheet. Keep in mind, calculating your debt ratio is dependent on the type of ratio and information you're working with. Here are the steps to calculate the general debt ratio:
1. Determine your total liabilities
Your company's total liabilities are the sum of its debts and other financial obligations. It's a combination of both current and long-term liabilities. Find this number to begin the debt ratio calculation process. You can find this amount listed on your company's financial statements.
Examples of total liabilities include utility bills, credit card debt, wages payable or notes payable. For the most part, it's the money your company owes at a certain point in time.
Tip: Your balance sheet will provide you with the totals you need in order to calculate your debt-to-asset ratio. Be sure to run the balance sheet for the appropriate time frame.
2. Determine your total assets
In a business sense, "total assets" refers to the total number of assets owned by your company. While assets hold value, they also have the potential to depreciate with time. Find this number in your company's accounting records and balance sheet. Examples of total assets include inventory, goods or accounts receivable. They are the entities in which your company possesses ownership.
3. Calculate the debt ratio
Once you've found both your total liabilities and total assets, you can calculate your debt ratio. To calculate the debt-to-assets ratio, divide your total debt by your total assets. To calculate another type of debt ratio, refer to the various types listed above.
It's important to note that whether or not your debt ratio is low or high depends on your particular industry. However, a debt ratio greater than one indicates a more risky financial future, while a lower debt ratio, generally around 0.5, implies your business is on good financial ground and has the potential for longevity.
Tip: Be sure to divide liabilities into assets, otherwise, your results will be inaccurate.
Examples of debt ratios
To adequately understand debt ratios and how to calculate them for your own personal and business purposes, consider the following examples:
If your company has $100,000 in business loans and $25,000 in retained earnings, its debt-to-equity ratio would be 4. This is because $100,000 (total liabilities) divided by $25,000 (total equity) is 4 (debt ratio). This would be considered a high-risk debt ratio and a risky investment.
Let's say your shoe store owes its employees $50,000 and has total assets amounting to $100,000. To calculate the debt ratio, divide $50,000 (liabilities) by $100,000 (assets). This means your shoe store has a debt ratio of 0.5. Though it'll depend on your industry and competitors, this debt ratio is generally considered favorable.
Let's say your aromatherapy store needs expansion. To expand upon your current location, you'll need to consult with your bank about a loan. The bank determines your store has total assets of $50,000 and total liabilities of $5,000. They would calculate your debt ratio by dividing $5,000 by $50,000. This would result in a debt ratio of 0.1.
This is a highly favorable and rather low-risk debt ratio. Under these circumstances, your bank shouldn't have a problem providing you with a loan for your aromatherapy store expansion.
Your family is anticipating the adoption of another child into the family. Because of this, you and your partner have decided to buy a new home. To do so, you’ll need to take out a loan. Your bank or lender will need to calculate your debt ratio to decide whether or not they want to give you a loan.
Let's say you have $600,000 in total assets and $150,000 in liabilities. To calculate your debt ratio, divide your liabilities ($150,000) by your total assets ($600,000). This will give you a debt ratio of 0.25 or 25 percent. Because this is below 1, it'll be seen as a low-risk debt ratio and your bank will likely approve your home loan.
Frequently asked questions
What are common debt ratio types?
To fully understand debt ratio, you should understand how to calculate various forms:
Debt-to-assets ratio: This is the general debt ratio formula. To calculate the debt-to-assets ratio, divide your total debt by your total assets. The larger your company's debt ratio, the greater its financial leverage.
Debt-to-equity ratio: This is the more common debt ratio formula. To calculate it, divide your company's total debt by its total shareholder equity.
Debt-to-capital ratio: To calculate your company's debt-to-capital ratio, divide its total debt by the sum of its debt and total equity.
Debt-to-EBITDA ratio: This ratio is calculated by dividing your company's total debt by its earnings before interest, taxes, depreciation and amortization (EBITDA).
Debit-to-income ratio: This is the formula used by lenders to determine a client's ability to pay off a loan given the amount of money they already owe.
Why is debt ratio important?
The debt ratio of a company is important because:
It tells a company’s top management how capable they are of repaying debts. If the debt ratio is too high, management can take steps to implement cost-saving measures.
It is analyzed and evaluated by investors to help them decide whether they should put their money into a company or not.
What is a good debt ratio?
Investors generally want a company’s debt ratio to be between 0.3 and 0.6. 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. A company with too little debt can be a warning to investors that it's operating with extremely tight margins or that it doesn’t finance increased operations through borrowing at all, which limits the total return that can be passed on to investors and shareholders.
Can a debt ratio be negative?
If a company has a negative debt ratio, this means that it has negative shareholder equity. This means that the company's liabilities outnumber its assets and is considered a sign of high risk or bankruptcy and an incentive to seek bankruptcy protection.
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