What is a Debt Ratio?
The debt ratio is a debt financial ratio used to measures the degree of leverage of a company. This ratio can be expressed as the ratio of total debt to total assets, articulated as a decimal or percentage.
It may be interpreted as the proportion of a firm’s assets that are financed by debt.
A ratio is greater than one shows that a considerable portion of debt is funded by assets. In other language, the firm has more liabilities than its assets.
A high value of this ratio indicates that a firm may be throwing itself at a risk of default on its debt if interest rates were to rise suddenly.
When the value of this ratio is below one that shows that a greater portion of a firm’s assets is funded by equity.
Advantage of Debt Ratio
- It is issuing bonds and borrowing money from lenders is that a company maintains complete ownership.
- Interest paid on debt by the Companies can d for tax deductions from the income.
- Owner makes all the decisions.
- The business relationship ends once you have repaid the loan in full.
- This ratio help to makes easy to budget and make financial plans.
Disadvantage of Debt Ratio
- To get finance from a financial institution, company need very good credit rating.
- When a business is over dependent on loan or debt may be seen as ‘high risk’
- By agreeing to provide collateral to the lender potentially putting your own assets at risk.
- Small business to make regular monthly payments of principal and interest, its difficult for very young company.
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Debt Ratio Formula
The this ratio can be computed using this formula:
Analysis and Interpretation of Debt Ratio
It is represented in decimal format since it calculates the total liabilities as a percentage of total assets. Like many solvency ratios, a lower ratio is more favorable than a better ratio.
A lesser this ratio generally implies a more stable business with the potential of durability because a firm with lower ratio also has lower overall debt.
Each industry has its own benchmarks for debt, but .5 is affordable ratio.
This ratio of .5 is usually considered to be less risky. this implies that the firm has twice as many assets as liabilities. Or said a distinct way, this company’s liabilities are only 1/2 its total assets
A ratio of 1 means total liabilities equals total assets. In other words, the firm would ought to sell off all of its assets so as to pay off its liabilities.
Obviously, this can be a highly leverage firm. Once its assets are sold off, the business no more can operate.
It could be a fundamental solvency ratio because creditors are always concerned about being repaid.
When companies borrow extra money, their ratio increases creditors will no more loan them money. Companies with higher these ratios are more contented looking to equity financing to grow their operations.
Example of Debt Ratio
The following figures are obtained from the balance sheet of XYL Company.
|Total liabilities and equity||15,600,000|
The above figures will provide us with this ratio of 73.59%, computed as follows:
|DR||=||Debt / Assets|
|=||11,480 / 15,600|
Alternatively, if we know the equity ratio we can easily compute for the this ratio by subtracting it from 1 or 100%. Equity ratio is equal to 26.41% (equity of 4,120 divided by assets of 15,600).
Using the equity ratio, we can compute it for the company.
|DR||=||1 – Equity ratio|
|=||1 – .2641|
|=||.7359 or 73.59%|