What Is A Debt Ratio? (Plus How To Calculate It And FAQs)

Updated 20 October 2022

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Businesses and investors may use a variety of metrics to analyse and predict the financial performance of a company. For example, lenders may use a ratio to compare an organisation's debt and its assets to determine whether the company is a worthwhile investment. Understanding the significance of this ratio can help you make well-informed business and financial decisions. In this article, we define what a debt ratio is, describe how to calculate it, explore interpreting the results, address several frequently asked questions about this topic and provide an example.

What Is A Debt Ratio?

A debt ratio, or debt to asset ratio, is a metric companies use to compare their total assets and total debts to evaluate their financial leverage. Accounting professionals use this tool to analyse how many assets a business purchased with debt. Potential lenders may refer to this ratio when determining whether to invest in a company and assess the associated risk. As it is also an indicator of a company's ability to leverage funds, it shows the potential for increased borrowing. This may generate greater returns, making it an attractive option for potential investors. Here is the formula:

Debt ratio = (Total debts) / (Total assets)

For this formula, debts include all of a company's short- and long-term liabilities, also known as financial obligations. Short-term liabilities include aspects like rent, payroll or accounts payable. Long-term liabilities include aspects like pension obligations or financial loans. Short-term debt typically includes finances that a business plans to repay within a year, while long-term debt usually has a maturity of more than one year. Assets refer to anything that a company owns that has value. This includes cash, property, product inventory or investments.

How To Calculate Debt To Asset Ratio

Here is a list of steps you can take if you are interested in learning how to calculate this ratio:

1. Total a company's debts

To begin calculating this ratio, it is important to total all elements of the equation, beginning with the company's total debts. This involves reviewing all the organisation's long-term and short-term liabilities and adding them to produce a single sum. You may want to reference the business' most recent financial reports, such as a balance sheet, to retrieve this information. Referencing these resources can help you save time when making these calculations.

2. Total a company's assets

After calculating the total debts, you can also analyse the sum of the company's total assets. This typically involves combining both tangible and intangible assets. Tangible assets are items such as real estate or company inventory, while intangible assets include investments and cash. You may also reference a balance sheet to locate this information and save time when performing these calculations.

3. Divide the total debts by the total assets

Once you have calculated both the company's debts and its assets, you can enter these figures into the formula. You then divide the total debts by the total assets and receive a result that is a value between zero and one. This decimal value is your ratio. To calculate it into a percentage, you can multiply this number by 100. This step is important because many professionals typically address this ratio as a percentage.

Interpreting Results

Lenders and investors may consider a ratio at or below 0.4 or 40% to be low, which indicates minimal risk, potential longevity and strong financial health for a company. Alternatively, a ratio above 0.6 or 0.7 (60% to 70%) may produce higher risk and may discourage investment. The ratio value of 1.0, indicated that the total debts equal the total amount of assets.

In addition to the raw score, lenders and investors consider a company's credit and payment history when making investment decisions. Strong credit and positive payment history may offset the perceived risk for a prospective lender. A company's industry context may also be a factor that lenders consider. Certain industries are capital intensive, meaning they require substantial spending to produce a good or service and maintain high debt ratios. This includes airlines, telecommunications and utility companies. Comparing a specific company's ratio to that of comparable competitor's provides a more complete context for a prospective investor.

Frequently Asked Questions About This Ratio

Here are some frequently asked questions about this ratio and its implications:

Why is this ratio important?

It may be important for a company to calculate its debt ratio to understand its ability to repay its debt or make future purchases using debt. This can help the organisation's finance and management departments make well-informed decisions and avoid acquiring more debts than assets. Investors may also want to review this ratio before deciding to contribute funds to a growing business, as it allows them to evaluate potential risks and determine whether it is a worthwhile investment.

What is a good ratio when comparing debts and assets?

A good value for this ratio may convince a lender or investor to make a financial contribution to a business and can indicate that the company has significant financial leverage. Identifying whether a company's ratio is good or bad typically depends on the industry, as some fields may include companies that are more likely to have higher ratios than other organisations.

Companies typically regard any ratio below one to be good, and a ratio above one to have negative implications. They can use this information to make informed decisions regarding loans, transactions and purchases to change their financial situation if necessary.

Can these ratios be negative?

When calculating this ratio for a company, it is important to understand that your calculation may be negative, but only if the organisation has negative shareholder equity. This means the company has more liabilities than assets. Typically, investors and lenders perceive a negative ratio as an indication of substantial risk, and the business may even be at risk of bankruptcy. If a company's financial team determines that the business has a negative ratio, it is essential for them to implement new processes and monitor the organisation's financial health closely.

Example Of This Ratio In Business

When deciding whether to loan money, potential lenders consider a company's current debt to asset ratio and what it may be if the company received its desired loan. Here is an example of how to calculate it for a company seeking a new loan:

Freeze, a family-owned ice cream business wants to expand to open a second location. This company currently has ₹15,000 in short-term liabilities and ₹125,000 in long-term liabilities, making its total debts equal to ₹140,000. To open the second location, they apply for a $200,000 loan to cover modest store renovations, specialised equipment and rent for the first six months of operations. If approved, Freeze's debt payment is then ₹5,000, making their total debts equal to ₹145,000. This company also has ₹110,000 of tangible assets, mostly as equipment, and $45,000 of intangible assets for a total of ₹155,000 in assets.

This company's debt to asset ratio is ₹145,000 divided by ₹155,000, which is 0.93 or 93%. Although a high ratio can discourage lenders from approving the loan, if marketed strategically, they can charge higher prices for their custom product than a chain ice cream business can. A prospective lender has to determine whether the unique context for this business and location justifies the financial risk of lending to a company with a high debt to asset ratio.

Please note that none of the companies, institutions or organisations mentioned in this article are associated with Indeed.