Debt Ratio Explained
Debt ratio is a financial formula that investors use to determine a company's financial strength. Companies with high debt ratios carry considerable risk if sales fall and the company cannot meet its debt obligations.
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Formula
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The numbers used to calculate the debt ratio are taken from a company's balance sheet. The classic formula is total debt divided by total assets.
Total Debt
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Total debt includes all forms of debt included on the company's balance sheet; current liabilities are not included in this number. Long-term leases and obligations may also be included, depending on how the company has recorded these items in its financial statements.
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Total Assets
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Total assets include current and non-current assets for the debt ratio. The rationale for including current assets comes from companies being forced to earn cash to pay creditors if the company defaults on loan obligations.
Meaning
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A debt ratio of 1 means that a company has $1 of assets for every $1 of debt; ratios higher than 1 indicate that a company that may have over-leveraged their assets.
Improving the Debt Ratio
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Companies should avoid using debt to fund their operations or expansion plans. Using cash-on-hand or offering stock to raise capital are excellent alternatives to obtaining debt for business purposes.
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