Debt ratio
Debt ratio is a financial ratio that indicates the percentage of a company's assets that are provided via debt. It is the ratio of total debt and total assets:
- Debt ratio = Total Debts/Total Assets = Total Liabilities/Total Assets
- where, total debt comprises short-term and long-term liabilities and total assets is the sum of current assets, fixed assets, and other assets such as 'goodwill'.
Applying this, as an example, a company with $2 million in total assets and $500,000 in total liabilities would have a debt ratio of 25%. Thus, if the ratio is less than 50%, most of the company's assets are financed through equity; if greater, most of the company's assets are financed through debt.
Financial analysts and financial managers will use the ratio in assessing the financial position of the firm. Companies with high debt to asset ratios are said to be highly leveraged. Here, for a higher ratio, greater risk will be associated with the firm's operation. (See Hamada's equation.) In addition, a high debt to asset ratio may indicate a low borrowing capacity, which in turn will limit the firm's financial flexibility. Like all financial ratios, a company's debt ratio should be compared only with its industry average or with that of other competing firms.
See also[edit]
- Equity ratio
- Debt-to-income ratio, for households
- Debt-to-GDP ratio, for governments
References[edit]
- Corporate Finance: European Edition, by D. Hillier, S. Ross, R. Westerfield, J. Jaffe, and B. Jordan. McGraw-Hill, 1st Edition, 2010.
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