What is Debt Ratio?
The term debt ratio is a financial amount that measures the leverage of a business. The ratio can be expressed in decimals or percentages. This ratio can be understood as the percentage of assets financed by debt.
A ratio higher than 1 indicates that the assets of a business are financed by debt. This means there are more liabilities than assets. A high ratio can indicate that a business is at risk of defaulting on its loan if interest rates suddenly increase. A ratio less than 1 indicates that the majority of a company’s assets are funded by equity.
Debt Ratio Formula
The debt ratio of a business is a measurement of its financial leverage. This ratio can vary widely between industries. The ratios of capital-intensive companies, like utilities and pipelines, are much higher than those in the tech sector.
The formula to calculate a company’s ratio of debt is:
Debt ratio = Total debt / Total assets
The Advantages and Drawbacks
The Pros
It is simple to calculate and understand. The ratio gives an overview of the amount of debt that a company has in relation to its total assets. These figures are often available because public companies have to report them as part of periodic external reporting.
It is possible to compare businesses within the same industry by comparing their ratios. This can be used to compare debt levels between companies. You can compare the calculation to other ratios over time or with competitors.
The Cons
Comparing them between companies is great, but the capital intensity and the need for debt vary widely among sectors. Comparing ratios between industries may not accurately represent the financial health of an organization. Be aware that certain industries require higher ratios because of the initial investment required.
It is also a reliable indicator of the financial health of a business at any given time. The ratio can be affected by a number of factors, including acquisitions, sales, or changes in asset values. Analysts may be misled if they draw conclusions solely based on historic ratios, without considering future predictions.
