Debt Ratio Definition
The debt ratio is solvency which is used to measure the ability of the firm or company’s total liabilities as a percentage of its assets. Debt ratio shows how the company pays off its liabilities with its assets. In simple words how many assets company require to sell, in order to pay off its total liabilities.
This ratio is used to measure the financial leverage of the company or firm. The company which has high liabilities as compared to assets is the more risky company for investors and lenders. This high debt ratio company is called high leverage company.
So from this ratio analysts and investors find the debt burden on the company and the ability of the company to pay off this debt burden in future.
We can get debt ratio by the formula in which we divide the total liabilities by total assets and the value of these available on the balance sheet of a company.
Debt ratio = Total liabilities/ Total assets
Debt ratio used to find out the total debt burden on the company for which division of total liabilities and total assets must be required.
The result of debt ratio always in the decimal format because it gives the result in percentage. Just like other solvency ratios lower debt ratio is better than the high debt ratio.
More stable business usually have a low debt ratio. Because these companies have lower debt overall. For every company, there is a different benchmark but if the result of this is .5 then it will be a reasonable ratio.
If the debt ratio of any company is 0.5 then it means that to pay off its liabilities company has double assets. Or we can say that a company has 50% labilities as compared to total assets. Half assets of the company own by the creditor whereas half own by the shareholder.
If the result of the debt ratio is 1 then it means that the total liabilities of the company is equal to the total assets of the company. So if the company sold its assets to pay off its total liabilities then the company have no extra money to operate its business longer.
The fundamental solvency ratio is a solvency ratio. Because creditor wants to repay. If the debt ratio of the company increase then creditor no longer pay money to that company.
A company D want to construct the building as a store for which company D apply for the loan. Banker checks the balance of this company to examine its overall debt level.
Total liabilities of this company is $25,000 and total assets of this company are 100,000 dollars. So by bank debt ratio calculated as
So the debt ratio of this company is 0.25 which means that a company has 4 times greater than assets than the total liabilities of the company. This is the low debt ratio company which will be considered as a good company. So for the approval of loan this company does not face the problem.
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