The debt ratio is a financial ratio that relates to the solvency levels in a company as they assess the debt to asset ratio. The debt ratio shows the company’s ability to pay off liabilities with the use of its assets. That would demonstrate the number of assets the company would have to sell to pay off the liabilities in full.

It illustrates a particular perspective concerning corporate finance, and that indicates the leverage held. The firm may be financed by debt, equity, or even both. It also considers the short and long-term assets by applying both of them within the calculation of the total assets when set against the total debt.

What the Debt Ratio Shows

The debt ratio shows the level of risk which the business has attained. The preferable thing is for a low-risk level, which means a business that is not too reliant on borrowed funds. So it would be financially stable. Businesses that have low ratios, meaning 0.5 and below, show the assets are wholly owned. Companies with high debt ratios; 0.5 and above are termed as highly leveraged.

The higher the amount of debt, the greater the risk related with a company’s operations. A low ratio indicates conventional financing with the ability to borrow in the future with limited risk.

The majority of a company’s assets are financed through debt rather than equity. A high debt ratio illustrates the business is in a bad financial state should the creditors decide on repayment of loans. That is the reason why lower ratios are preferred. To attain a good debt ratio, businesses need to compare their position to the industry’s average or the most significant competitors.

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Formula

It is illustrated as dividing the liabilities by the total assets

Debt Ratio = Total Liabilities / Total Assets

Example

A startup has been running for six months, and they consult the bank concerning their chances of getting a new loan for expansion. The financial institution asks for the balance, so they evaluate the total levels of debt. It is discovered that the total assets number $124,000 while the liabilities are at $93,000. The debt ratio for the startup would be calculated as

$93,000/$126,000 = 0.75

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.  That level of debt can compromise the operation should the cash flow end. The firms that cannot service their debt can have to sell their assets and declare solvency.

Analysis

The debt ratio tends to be in decimal format as it calculates the total liabilities according to a percentage of the total assets. Similarly, as with many solvency related ratios, a lower figure would be favorable than the higher ratios. A low debt ratio means the business is stable, and there is more potential longevity because it has low levels of debt overall. Each sector has different benchmarks for the leverage, but 0.5 has been deemed as the common midpoint.

Since utility companies usually have a lot of company debt on their balance sheets, the debt ratio is useful in determining how many years of EBITDA it would take to pay back all the debt.

Lender Limits

Lenders usually have limits concerning the debt ratio above which they would not extend credit to organizations because they are overleveraged. Obviously, there are other things to consider,  including payment history, professional relations, and the business’s credit. The investors, though, may rarely desire to buy company stock when there are very low debt ratios.

Should the debt ratio be at zero, it would mean that the business may not finance a lot of operations through borrowing in the first place. That means it is very risk-averse, and so there is a slow rate of return, which would be realized so the shareholders cannot depend on dividends quickly. Other ratios are better at assessing leverage, such as the debt to equity ratio, because it measures the opportunity costs.

Usually, the larger and stable organizations can push on the ledgers’ liabilities compared to the smaller firms. They also tend to have better and more robust cash flows as they can negotiate with lenders due to the economies of scale involved. The debt ratios also happen to be sensitive to interest rates.

All of the assets with interest rates have risk, whether they are loans or bonds. The same amount is costly to pay regardless of a 5 of 10% interest rate. There is a sense that the ratio analysis has to be done based on company-by-company. Balancing the dual risks of company debt and the opportunity costs is essential for all organizations.


Chris Douthit
Chris Douthit

Chris Douthit, MBA, CSPO, is a former professional trader for Goldman Sachs and the founder of OptionStrategiesInsider.com. His work, market predictions, and options strategies approach has been featured on NASDAQ, Seeking Alpha, Marketplace, and Hackernoon.