Debt ratio calculates the extent of a company’s leverage, expressed as a percentage or decimal.
The formula for debt ratio is as follows:
Debt ratio = Total Debt ⁄ Total Assets
When a company’s debt ratio is greater than 1.0 (or above 100%), it shows that the company has more liabilities than assets. A debt ratio below 1.0 indicates that a company has more assets than debt. A high ratio shows that the company may be at risk of default if their loan’s interest rates were to suddenly rise.
If a debt ratio is below zero (negative), it shows that the company has more liabilities than assets. This figure is often a sign that a company may be at risk of bankruptcy.
Acceptable levels of debt ratio vary from industry to industry. Capital-intensive businesses (e.g. steel production) have much higher debt ratios than other industries like the services sector. In an industry with volatile cash flows, businesses do not take on much debt.
A debt ratio of 40% may show a company to be in either a good or bad financial situation, all depending on the industry.
Consumers also use debt ratio, such as when taking out a loan. Mortgage lenders generally require a debt ratio of 36%> to successfully take out a mortgage.
Debt ratio is measuring how leveraged a company is. The more leveraged a company is, the greater the financial risk. In saying this, leverage is a major tool that businesses can use to grow — it is all about finding a safe and sustainable use for debt.
The total debt to total assets ratio (debt ratio) includes all debts, both long-term (e.g. mortgages) and short-term (e.g. rent). However, there is an alternative ratio called the long-term debt to equity ratio which only accounts for long-term debts. Both the total debt and long-term debt to asset ratios include all of a business’s assets.