Debt Ratio: Interpreting, Calculating, and Optimizing Financial Health
Using this metric, analysts can compare one company’s leverage with that of other companies in the same industry. Depending on averages for the industry, there could be a higher risk of investing in that company compared to another. This is a relatively low ratio and implies that Dave will be able to pay back his loan. This helps investors and creditors analysis the overall debt burden on the company as well as the firm’s ability to pay off the debt in future, uncertain economic times.
Total Debt-to-Total Assets Formula
For example, a company may choose to lease assets instead of purchasing them, which can result in lower debt levels and a lower debt ratio. Therefore, it is important to analyze a company’s financial statements and understand its accounting policies before making any conclusions based on its debt ratio. Another common mistake to avoid while interpreting debt ratio is solely relying on this metric to assess a company’s financial health. Debt ratio should be used in conjunction with other financial ratios, such as liquidity ratios and profitability ratios, to get a more comprehensive understanding of a company’s financial position. There is no one-size-fits-all answer to what the ideal debt ratio is for businesses.
Total Debt-to-Total Assets Ratio: Meaning, Formula, and What’s Good
Balancing the dual risks of debt—credit risk and opportunity cost—is something that all companies must do. Remember, understanding your debt ratio is a critical part of managing financial health, whether you’re running a business or considering an investment decision. A lower debt ratio often signifies robust equity, indicating resilience to economic challenges.
Economic Conditions
Ask a question about your financial situation providing as much detail as possible. Our team of reviewers are established professionals with decades of experience in areas of personal finance and hold many advanced degrees and certifications. At Finance Strategists, we partner with financial experts to ensure the accuracy of our financial content.
- Therefore, the company had more debt ($18.2 billion) on its books than all of its $15.7 billion current assets (assets that can be quickly converted to cash).
- It is calculated by dividing total liabilities by total assets, with higher debt ratios indicating higher degrees of debt financing.
- Contrarily, if the company’s assets yield low returns, a low debt ratio does not automatically translate into profitability.
How Do I Calculate Total Debt-to-Total Assets?
Keep reading to learn more about what these ratios mean and how they’re used by corporations. One shortcoming of the total debt-to-total assets ratio is that it does not provide any indication of asset quality since it lumps all tangible and intangible assets together. For example, Google’s .30 total debt-to-total assets may also be communicated as 30%.
Some industries, such as banking, are known for having much higher debt-to-equity ratios than others. Common debt ratios include debt-to-equity, debt-to-assets, long-term debt-to-assets, and leverage and gearing ratios. Some sources consider the debt ratio to be total liabilities divided by total assets. This reflects a certain ambiguity between the terms debt and liabilities that depends on the circumstance. The debt-to-equity ratio, for example, is closely related to and more common than the debt ratio, instead, using total liabilities as the numerator.
Based on this indicator, top management recognizes whether the company has sufficient resources to meet its obligations. It is important to note that a high debt ratio may indicate that a company is taking on too much debt and may have difficulty paying it back. On the other hand, a low debt ratio may indicate that a company is not taking advantage of potential growth opportunities by avoiding debt. From the calculated ratios above, Company B appears to be the least risky considering it has the lowest ratio of the three. As is often the case, comparisons of the debt ratio among different companies are meaningful only if the companies are similar, e.g. of the same industry, with a similar revenue model, etc.
The debt-to-equity ratio, often used in conjunction with the debt ratio, compares a company’s total debt to its total equity. Stakeholders, especially creditors, may view a high debt ratio as an increased risk, potentially impacting the company’s borrowing costs and terms. In the context of the debt ratio, total assets serve as an indicator https://www.simple-accounting.org/ of a company’s overall resources that could be utilized to repay its debt, if necessary. Company managers can compare a firm’s debt-to-capital ratio to those of other companies within an industry, as well as against averages for all businesses. Generally, the higher the debt-to-capital ratio is, the riskier it is for a business.
This assessment can be particularly vital for creditors, investors, and other stakeholders when evaluating the financial health of an organization. The broader economic landscape can serve as a lens through which a company’s present value of future cash flows debt ratio is viewed. In contrast, companies looking to expand or diversify might again increase borrowing, potentially raising the ratio. Understanding where a company is in its lifecycle helps contextualize its debt ratio.
As a highly regulated industry making large investments typically at a stable rate of return and generating a steady income stream, utilities borrow heavily and relatively cheaply. High leverage ratios in slow-growth industries with stable income represent an efficient use of capital. Companies in the consumer staples sector tend to have high D/E ratios for similar reasons. If interest rates are higher when the long-term debt comes due and needs to be refinanced, then interest expense will rise. Business owners use a variety of software to track D/E ratios and other financial metrics.
If the ratio is too high, it may indicate that the company’s earnings are not enough to cover the cost of its debts and other liabilities. A steadily rising D/E ratio may make it harder for a company to obtain financing in the future. The growing reliance on debt could eventually lead to difficulties in servicing the company’s current loan obligations.
It simply means that the company has decided to prioritize raising money by issuing stock to investors instead of taking out loans at a bank. While a lower calculation means a company avoids paying as much interest, it also means owners retain less residual profits because shareholders may be entitled to a portion of the company’s earnings. A high ratio can indicate that the business relies heavily on debts to finance its assets, which might make it a risky investment. In contrast, a lower ratio often indicates that a company primarily uses equity to finance its assets, which can portray financial stability. So, you can use this ratio to understand how much risk your business is taking on. At its core, the debt ratio compares a company’s total debt to its total assets.
Lenders and debt investors prefer lower D/E ratios as that implies there is less reliance on debt financing to fund operations – i.e. working capital requirements such as the purchase of inventory. In general, if a company’s D/E ratio is too high, that signals that the company is at risk of financial distress (i.e. at risk of being unable to meet required debt obligations). Credit card issuers, loan companies, and car dealers can all use DTI to assess their risk of doing business with different people. A person with a high ratio is seen by lenders as someone that might not be able to repay what they owe. There is a separate ratio called the credit utilization ratio (sometimes called debt-to-credit ratio) that is often discussed along with DTI that works slightly differently. The debt-to-credit ratio is the percentage of how much a borrower owes compared to their credit limit and has an impact on their credit score; the higher the percentage, the lower the credit score.
In the consumer lending and mortgage business, two common debt ratios used to assess a borrower’s ability to repay a loan or mortgage are the gross debt service ratio and the total debt service ratio. The concept of comparing total assets to total debt also relates to entities that may not be businesses. For example, the United States Department of Agriculture keeps a close eye on how the relationship between farmland assets, debt, and equity change over time. From the above, we can calculate our company’s current assets as $195m and total assets as $295m in the first year of the forecast – and on the other side, $120m in total debt in the same period.
This team of experts helps Finance Strategists maintain the highest level of accuracy and professionalism possible. Such comparisons enable stakeholders to make informed decisions about investment or credit opportunities.
