Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Debt Ratio

What it is:

A debt ratio is simply a company's total debt divided by its total assets. 

How it works (Example):

The formula for the debt ratio is:

Debt Ratio = Total Debt / Total Assets

For example, if Company XYZ had $10 million of debt on its balance sheet and $15 million of assets, then Company XYZ's debt ratio is:

Debt Ratio = $10,000,000 / $15,000,000 = 0.67 or 67%

This means that for every dollar of Company XYZ assets, Company XYZ had $0.67 of debt. A ratio above 1.0 indicates that the company has more debt than assets.

Why it Matters:

The debt ratio quantifies how leveraged a company is, and a company's degree of leverage is often a measure of risk. When the debt ratio is high, the company has a lot of debt relative to its assets. It is thus carrying a bigger burden in the sense that principal and interest payments take a significant amount of the company's cash flows, and a hiccup in financial performance or a rise in interest rates could result in default.

When the debt ratio is low, principal and interest payments don't command such a large portion of the company's cash flows, and the company is not as sensitive to changes in business or interest rates from this perspective. However, a low debt ratio may also indicate that the company has an opportunity to use leverage as a means of responsibly growing the business that it is not taking advantage of.