Debt ratio
/What is the Debt Ratio?
The debt ratio measures the proportion of assets paid for with debt. You can use the ratio to reach conclusions about the solvency of a business. A high ratio implies that the bulk of company financing is coming from debt; this is a risky financial structure, since the borrower is at risk of not being able to pay for the associated interest expense or paying back the principal. A low debt ratio reflects a conservative financing strategy of using only equity to pay for assets. Lenders and creditors use the debt ratio to estimate the amount of lending risk they will incur by extending credit to an organization. They are more likely to lend when the debt ratio is closer to 0% than when the ratio is closer to 100% (or more).
Generally, the debt ratio should be kept low if a company's cash flows are subject to a large amount of unpredictable variation, since it may not be able to service the debt in a reliable manner. This situation is most likely to arise in industries that experience large amounts of competition and/or rapid product cycles. Conversely, a business in an oligopoly or monopoly situation enjoys steady and reliable cash flows, and so can more easily pile on additional debt with little risk of not being able to pay it back to the lender.
Related AccountingTools Courses
The Interpretation of Financial Statements
How the Debt Ratio Varies by Industry
It is common to see higher debt ratios in asset-intensive industries (such as production and oil refining), since a business in these industries has a large asset borrowing base that it can use to acquire debt.
How to Improve Your Debt Ratio
There are several ways to improve your debt ratio. Here are several options to consider:
Redirect cash flow. Rather than funding internal investments, use some of that excess cash to pay down your debt level.
Shrink working capital. Work on reducing your accounts receivable with a tighter credit policy, or reducing your inventory with tighter inventory management. This reduces your working capital investment, leaving extra cash to pay down your debt.
Sell shares. Sell some equity in the company to investors, and use the cash to pay down your excess debt.
Formula for the Debt Ratio
The debt ratio is calculated as total debt divided by total assets. The formula is:
Total debt ÷ Total assets
A variation on the debt formula is to add all liabilities to the numerator, including accounts payable and accrued expenses.
Example of the Debt Ratio
As of its last financial statements, ABC International had $500,000 of debt outstanding on its balance sheet, as well as $1,000,000 of assets. The result is a fairly high 50% debt ratio, which is calculated as:
$500,000 Total debt ÷ $1,000,000 Total assets