Debt Ratio

Moneybestpal Team

A financial ratio known as the debt ratio gauges a company's level of leverage or the percentage of assets that are financed by debt. When represented as a decimal or percentage, the debt ratio is the proportion of total debt to total assets. 

Total obligations, such as accounts payable, notes payable, bonds payable, and mortgages payable, are both short- and long-term liabilities. Cash, inventory, real estate, machinery, and intangible assets are examples of current and non-current assets that are included in total assets.

The debt ratio formula is:

Debt Ratio = Total Debt / Total Assets

For example, if a company has total debt of $110,000 and total assets of $330,000, its debt ratio is:

Debt Ratio = $110,000 / $330,000 = 0.33 or 33%

This means that 33% of the company's assets are financed by debt and 67% are financed by equity.

A company's ability to satisfy its debt commitments and the level of risk it is incurring by using debt are both indicated by the debt ratio, which is a key metric of a company's financial health and solvency.

A lower debt-to-equity ratio indicates that the company is in a stronger financial position, has a reduced chance of default, pays less interest on its debt, and has a higher credit rating. An organization's financial condition is poorer, there is a higher chance of default, there is a higher cost of debt, and there is a lower credit rating if the debt-to-equity ratio is higher.

The debt ratio does not take into account the quality, composition, timing, and assets or the profitability and cash flow production of the organization, hence it is not a conclusive indicator of solvency. For instance, while certain assets have better liquidity or a higher rate of return on investment than others, some debts may have a longer duration or a lower interest rate. Additionally, the debt ratio may range across various markets, sectors, and industries depending on the kind, size, and stage of the company as well as the general financial and economic climate.

Thus, in order to obtain a more complete and accurate picture of the solvency of the company, the debt ratio should be used in conjunction with other solvency ratios, such as the debt-to-equity ratio, the interest coverage ratio, the cash flow-to-debt ratio, and the debt service coverage ratio. In order to evaluate the company's absolute and relative performance, the debt ratio should also be contrasted with the average for the industry, the historical trend, and the target or ideal level.

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