The debt ratio compares a company’s total debt to its total assets. This provides creditors and investors with a general idea as to the amount of leverage being used by a company. The lower the percentage, the less leverage a company is using and the stronger its equity position. In general, the higher the ratio, the more risk that company is considered to have taken on.
The debt ratio is calculated as follows:
Total Liabilities divided by Total Assets
If a company has $1 million in total liabilities and $3 million in total assets this means that for every dollar the company has in assets, it has 33 cents worth of liabilities.
If a company has $2 million in total liabilities compared to $3 million in total assets this means that for every dollar of assets the company has 67 cents worth of liabilities.
What does the debt ratio tell us?
The debt ratio tells us the degree of leverage used by the company.
If a company has a high debt ratio (the definition of high will vary by industry) this is an indication that the company must commit a significant portion of its ongoing cash flow to the payment of principal and interest on this debt.
On the other hand, a company that employs very little debt, especially if this is low compared to other companies in the same industry, may not be properly using leverage that might increase its level of profitability.
For example, utilities generally have a higher debt ratio than companies in many other industries due to the capital-intensive nature of the utility business.
Users of this data need to look beyond the ratio to determine what makes up the company’s liabilities. Items such as trade payables and goodwill might be excluded to provide a more accurate picture of the company’s long-term debt burden compared to their assets.