The debt ratio is a financial ratio used in accounting to determine what portion of a business's assets are financed through debt.
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A company's debt ratio offers a view at how the company is financed. This provides a clear indication of the amount of leverage held by a business. The company could be financed by primarily debt, primarily equity, or an equal combination of both.
The debt ratio takes into account both short-term and long-term assets by applying both in the calculation of the total assets when compared with total debt owed by the company.
What does the debt ratio indicate?
The debt ratio of a business is used in order to determine how much risk that company has acquired.
A low level of risk is preferable, and is linked to a more independent business that does not need to rely heavily on borrowed funds, and is therefore more financially stable. These businesses will have a low debt ratio (below .5 or 50%), indicating that most of their assets are fully owned (financed through the firm's own equity, not debt).
A high risk level, with a high debt ratio, means that the business has taken on a large amount of risk. If a company has a high debt ratio (above .5 or 50%) then it is often considered to be"highly leveraged" (which means that most of its assets are financed through debt, not equity).
In some instances, a high debt ratio indicates that a business could be in danger if their creditors were to suddenly insist on the repayment of their loans. This is one reason why a lower debt ratio is usually preferable. To find a comfortable debt ratio, companies should compare themselves to their industry average or direct competitors.
How to use the debt ratio
To find the debt ratio for a company, simply divide the total debt by the total assets. Total debt includes a company's short and long-term liabilities (i.e. lines of credit, bank loans, and so on), while total assets include current, fixed and intangible assets (i.e. property, equipment, goodwill, etc.).
The debt ratio:
Debt ratio = Total Debt/Total assets
For example:
- John’s Company currently has £200,000 total assets and £45,000 total liabilities.
- The debt ratio for his company would therefore be: 45,000/200,000.
- The resulting debt ratio in this case is: 4.5/20 or 22%.
- This is considered a low debt ratio, indicating that John’s Company is low risk.
Debt ratio and Debitoor
The easiest way to determine your company’s debt ratio is to be diligent about keeping thorough records of your business finances. This means registering your expenses, staying on top of any loans taken out, and tracking assets and depreciation.
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