Debt Ratio

The debt ratio, also called the debt to total asset ratio, is calculated by dividing a company's total liabilities by its total assets, producing a single figure indicating what proportion of the company's assets are financed by creditors rather than by its own owners. A debt ratio of 0.40, for instance, means 40% of the company's assets are financed through borrowing and other liabilities, with the remaining 60% financed through owner's or stockholders' equity.

A company with $800,000 in total assets and $320,000 in total liabilities has a debt ratio of 0.40, or 40%. A higher debt ratio means a company is relying more heavily on borrowed funds relative to its total asset base, which increases financial risk, since those liabilities must be repaid regardless of how the business performs, while a lower debt ratio means a greater share of the company's assets is funded by equity, which carries no fixed repayment obligation.

Lenders use the debt ratio as one of the first checks when evaluating a potential borrower's creditworthiness, since a company already heavily financed by debt has less capacity to take on additional borrowing safely and presents a greater risk of default if earnings weaken. A company's debt ratio also tells equity investors how much financial leverage they are exposed to, since a highly leveraged company's equity value tends to swing more dramatically, in both directions, with changes in the company's underlying operating performance.

There is no single universally correct debt ratio; acceptable levels vary considerably by industry, since capital-intensive businesses with predictable cash flows, such as utilities and real estate companies, can safely carry a much higher debt ratio than businesses with volatile earnings and few hard assets to serve as collateral, such as early-stage technology companies. Comparing a company's debt ratio against close industry peers, and tracking the trend over several periods, is generally far more informative than judging the figure against any single fixed benchmark applied across every industry.

The debt ratio and the closely related debt to equity ratio both measure leverage, but they express the same underlying information in slightly different ways: the debt ratio expresses liabilities as a share of total assets, while the debt to equity ratio expresses liabilities directly against equity. The two measures move together and can be converted into one another algebraically, but analysts often prefer the debt to equity ratio when the specific focus is comparing the relative size of debt and equity financing, and prefer the debt ratio when the focus is understanding what fraction of the total asset base is financed by obligations that must eventually be repaid.

Two companies each with $1 million in total assets might show very different debt ratios: one with $200,000 of total liabilities has a debt ratio of 0.20, while another with $700,000 of total liabilities has a debt ratio of 0.70. The second company is financing a much larger share of its asset base with borrowed money, meaning its owners have a smaller equity cushion to absorb losses if the value of those assets were to decline.