The debt ratio is calculated by dividing total liabilities by total assets. A lower debt ratio usually implies a more stable business with the potential of longevity. Every industry has different debt ratio standards and benchmarks. Some industries, like the real estate industry, tend to borrow more money than companies in the industrial machinery industry. A debt ratio of .7 could be considered high in one industry and standard in another. In general, companies should strive for a low debt ratio.
Like all liquidity ratios, the debt ratio is important to both creditors and investors. Creditors are concerned with companies’ financing strategies. Companies can either finance their asset growth with debt financing (bank loans and personal loans) or equity financing (payments from owners and stock issuances).If a company finances too much of its assets with debt, its debt ratio will be high. Creditors view companies with higher debt ratios as riskier borrowers because the company must sell more of its assets to pay for its liabilities in liquidation. Remember creditors are only concerned about having their money repaid.
In a nutshell:
- A debt ratio measures the amount of leverage used by a company in terms of total debt to total assets.
- This ratio varies widely across industries, such that capital-intensive businesses tend to have much higher debt ratios than others.
- A company's debt ratio can be calculated by dividing total debt by total assets.
- A debt ratio of greater than 1.0 or 100% means a company has more debt than assets while a debt ratio of less than 100% indicates that a company has more assets than debt.
- Some sources consider the debt ratio to be total liabilities divided by total assets.