Understanding the Debt Ratio: Definition and Formula (2024)

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The debt ratio is a financial metric that compares a business’ total debt to total assets. It’s a crucial ratio that analysts and finance professionals use to assess a company’s financial health. In this article, we’ll review the debt ratio and why it is an essential concept for students interested in corporate finance.

What Is the Debt Ratio?

The debt ratio shows how leveraged a company is. It provides insights into the proportion of a company’s financing derived from debt compared to assets. There are variants of this ratio that consider liabilities to equity. However, all leverage ratios measure how much a company relies on borrowed funds versus its own funds on some level.

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How to Calculate the Debt Ratio

Mathematically, the debt ratio is calculated by dividing a company’s total debt by total assets and multiplying the result by 100 to express it as a percentage. The formula is as follows:

(Total debt / Total assets) x 100

For instance, if a company has $500,000 in total debt and $1,000,000 in total assets, the debt ratio would be 50%:

(500,000 / 1,000,000) x 100 = 50%

You can skip the multiplication at the end and express the ratio as a decimal. For instance, in this example, the debt ratio would be 0.5.

Interpreting the Debt Ratio

The debt ratio is valuable for evaluating a company’s financial structure and risk profile. If the ratio is over 1, a company has more debt than assets. If the ratio is below 1, the company has more assets than debt. Broadly speaking, ratios of 60% (0.6) or more are considered high, while ratios of 40% (0.4) or less are considered low.

However, what constitutes a “good debt ratio” can vary depending on industry norms, business objectives, and economic conditions. For instance, startups or companies in rapid expansion phases, too, may have higher ratios as they utilize debt to fund growth initiatives. While a higher ratio can be acceptable, carefully analyzing the company’s ability to generate sufficient cash flows to service the debt is essential.

A good debt ratio should align with the company’s financial goals, risk tolerance, and industry standards. It should support the company’s ability to meet its financial obligations, maintain financial stability, and enable sustainable growth. Comparing a company’s ratio to industry peers, historical performance, and industry averages can provide valuable insights to determine what is considered favorable within a specific sector.

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Who Uses the Debt Ratio?

This fundamental financial metric is used by various stakeholders in corporate finance, including:

  • Financial analysts: Financial analysts play a crucial role in assessing a company’s financial performance and making investment recommendations. They rely on this metric to evaluate a company’s risk profile and financial stability. By analyzing the debt ratio, analysts gain insights into the level of financial leverage and the potential impact of debt on the company’s profitability and solvency.
  • Investors: Investors, including individual investors, institutional investors, and fund managers, closely examine the debt ratio when making investment decisions. A company with a favorable ratio may be financially sound and capable of generating consistent returns. Conversely, a high ratio might raise concerns about a company’s ability to manage its debt and fulfill its financial obligations. Investors consider the debt ratio as part of their overall risk assessment and investment strategy.
  • Lenders and creditors: Lenders and creditors, such as banks and financial institutions, rely on this metric to evaluate a company’s creditworthiness and determine its borrowing capacity. A lower ratio indicates a company is at a lower risk of defaulting on its loans and may be more likely to secure favorable financing terms. Lenders use this metric as one of the critical factors in assessing the company’s ability to service its debt and make timely interest and principal payments.
  • Management and executives: This metric is vital for management and executives in making informed financial decisions. It assists in determining the optimal capital structure for the company, balancing the use of debt and equity financing. By monitoring changes in this ratio, management can assess the impact of financing decisions on the company’s risk profile, profitability, and long-term sustainability.
  • Regulatory bodies like the U.S. Securities and Exchange Commission (SEC) may require companies to disclose thia metric as part of their financial reporting obligations. Credit rating agencies also use it as one of the factors in assessing a company’s credit rating. A higher ratio might lead to a lower credit rating, affecting the company’s ability to secure financing at favorable terms.

>>MORE: Is Finance a Good Career Path?

Showcasing You Understand the Debt Ratio on Your Resume

You can convey that you understand this calculation by including any of the following items on your resume:

  • In your skills section: Include “financial ratio analysis,” “debt ratio evaluation,” or “capital structure assessment” as skills to demonstrate your familiarity with financial metrics and your ability to analyze and interpret financial data.
  • Mention coursework: Highlight courses that cover financial analysis, financial management, or corporate finance, as these subjects typically delve into this and similar calculations.
  • Highlight work experience: Describe specific projects or responsibilities that assessed a company’s capital structure or financial health.

Other necessary calculations to master if you’re interested in this career path include the following:

  • Other leverage ratios, including the debt-to-equity (DE) ratio, the debt-to-capital ratio, and the asset-to-equity ratio.
  • The current ratio, which compares a company’s current assets to its current liabilities.
  • Quick ratio, which measures a company’s short-term liquidity against its short-term obligations.
  • P/E (price-to-earnings) ratio, which compares a company’s share price to its annual net profits.

Learn these and other in-demand skills today with Forage’s free job simulations.

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Understanding the Debt Ratio: Definition and Formula (1)

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Understanding the Debt Ratio: Definition and Formula (2024)


Understanding the Debt Ratio: Definition and Formula? ›

A company's debt ratio can be calculated by dividing total debt by total assets. A debt ratio of greater than 1.0 or 100% means a company has more debt than assets while a debt ratio of less than 100% indicates that a company has more assets than debt.

How do you interpret the debt ratio? ›

Interpreting the Debt Ratio

If the ratio is over 1, a company has more debt than assets. If the ratio is below 1, the company has more assets than debt. Broadly speaking, ratios of 60% (0.6) or more are considered high, while ratios of 40% (0.4) or less are considered low.

What does a debt ratio of 0.5 mean? ›

Debt Ratio = 0.50, or 50%

A company that has a debt ratio at this level has a perfect balance in its debt and equity funding and would also be considered a low risk for a potential financing source.

What's a good debt ratio? ›

If your debt ratio does not exceed 30%, the banks will find it excellent. Your ratio shows that if you manage your daily expenses well, you should be able to pay off your debts without worry or penalty. A debt ratio between 30% and 36% is also considered good.

What does a debt ratio of 0.4 mean? ›

If a company has a total debt-to-total assets ratio of 0.4, 40% of its assets are financed by creditors, and 60% are financed by owners' (shareholders') equity. The ratio does not inform users of the composition of assets nor how a single company's ratio may compare to others in the same industry.

What does a debt ratio of 90% mean? ›

E.g., if a company's debt represents 90% of its assets, it's probably considered high risk. Debt creates leverage in the financial results, meaning that a doubling of EBIT will more than double earnings.

What is a good ratio of debt to equity? ›

The optimal D/E ratio varies by industry, but it should not be above a level of 2.0. A D/E ratio of 2 indicates the company derives two-thirds of its capital financing from debt and one-third from shareholder equity.

Is 0.2 a good debt ratio? ›

Low debt ratio: If the result is a small number (like 0.2 or 20%), it means the company doesn't owe a lot compared to what it owns. This is usually a good sign. A lower debt ratio indicates a healthier financial position.

Is a debt ratio of 75% good? ›

A debt ratio below 0.5 is typically considered good, as it signifies that debt represents less than half of total assets. A debt ratio of 0.75 suggests a relatively high level of financial leverage, with debt constituting 75% of total assets.

Is 20% a good debt ratio? ›

Ideally, financial experts like to see a DTI of no more than 15 to 20 percent of your net income. For example, a family with a $250 car payment and $100 of monthly credit card payments, and $2,500 net income per month would have a DTI of 14 percent ($350/$2,500 = 0.14 or 14%).

What is an unhealthy debt ratio? ›

Debt-to-income ratio is your monthly debt obligations compared to your gross monthly income (before taxes), expressed as a percentage. A good debt-to-income ratio is less than or equal to 36%. Any debt-to-income ratio above 43% is considered to be too much debt.

Is rent considered debt? ›

Rent is an expense of living which is normally paid monthly on the first day of the month. If you haven't paid your rent by the second day of the month, it would be considered a debt.

How to calculate a debt ratio? ›

How to calculate your debt-to-income ratio
  1. Add up your monthly bills which may include: Monthly rent or house payment. ...
  2. Divide the total by your gross monthly income, which is your income before taxes.
  3. The result is your DTI, which will be in the form of a percentage. The lower the DTI, the less risky you are to lenders.

Is 0.3 a good debt ratio? ›

Key Takeaways

Whether or not a debt ratio is "good" depends on the context: the company's industrial sector, the prevailing interest rate, etc. In general, many investors look for a company to have a debt ratio between 0.3 and 0.6.

What does a debt ratio of 0.3 mean? ›

The ratio of total-debt-to-total-assets offers a look at how much a company finances assets using debt. This formula takes all types of debt and assets into account. This includes intangible assets. If your total-debt-to-total-assets ratio is 0.3, that means that 30% of your assets fall under credit.

What is a 0.75 debt ratio? ›

That means the debt ratio is 0.75, which is highly risky. It indicates for every four assets; there are three liabilities. The startup is highly leveraged, and there is a minimal chance that the bank would award the business the loan based solely on this information.

Is 0.5 a good debt ratio? ›

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.

Is 0.5 a good debt to asset ratio? ›

Although a ratio result that is considered indicative of a "healthy" company varies by industry, generally speaking, a ratio result of less than 0.5 is considered good.

Is a .5 debt to equity ratio good? ›

Generally, a good debt-to-equity ratio is less than 1.0, while a risky debt-to-equity ratio is greater than 2.0. But this is relative—there are some industries in which companies regularly leverage more debt. The debt-to-equity ratio by itself won't give you enough information to make an educated investment decision.

What does a debt ratio of 0.45 mean? ›

Debt-to-Capital Ratio

For example, if a company's debt-to-capital ratio is 0.45, it means 45% of its capital comes from debt. In such a case, a lower ratio is preferred, as it implies that the company can pay for capital without relying so much on debt.

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