A company's debt ratio is a comparison of its total debt at a given point to its total assets. In addition to using the debt ratio to evaluate financial leverage, companies pay close attention to their debt-to-equity ratio.
Basic Debt Ratio Meaning
The debt ratio allows a company to see what portion of its assets is leveraged with debt. High debt leverage exposes a company to the risks of missing payments, experiencing restricted cash flow, defaulting on loans and going bankrupt. In contrast, modest or reasonable debt leverage allows a company to more easily keep up with bill payments, utilize cash flow for growth and access new debt when necessary.
Interpreting Debt Ratio
A debt ratio of 0.5, or 50 percent, is normally a barometer for leverage. A ratio below this means more of a company's assets are financed through equity. A ratio above this means the company finances most of its assets through debt. The maximum ideal ratio is around 0.6 or 0.7, according to financial software provider Ready Ratios. However, different industries have distinct cost structures and levels of competition. It is possible that a company growing quickly in a competitive environment may have to rely more on debt to grow, for instance.
Basic Debt-to-Equity Ratio Meaning
Another ratio that offers a more direct comparison of debt and equity financing utilization is debt-to-equity ratio. This ratio reveals how much of each common financing source a company uses to acquire its assets. A debt-to-equity ratio of 1 means the business has a perfect balance of debt and equity. This ratio equates to a debt ratio of 0.5. If a company has total debts equal to $120,000 and total equity equal to $180,000, it has a debt-to-equity ratio of 0.667.
Interpreting Debt-to-Equity Ratio
As with a 0.5 debt ratio, a debt-to-equity ratio of 1 means a company maintains balanced financing. A company that carries a ratio over 1 has relatively high debt leverage, while a company that carries a ratio below 1 has low debt leverage relative to equity. The risks of high debt leverage and the benefits of low debt leverage are similar to those offered by a high or low debt ratio.