The debt ratio measures the extent to which a company’s assets are financed by debt. If an organisation has a high debt ratio, lenders may judge them to have a greater risk of defaulting on loans. But a lower debt ratio means assets are funded by equity and companies are more likely to see loan requests accepted.
In other words, lenders and banks use the debt ratio to better understand whether an applicant can afford to take on new debt.
What Is The Meaning Of Debt Ratio?
The meaning of debt ratio is defined as a company’s ratio of total debt to total assets. The debt ratio is calculated by dividing a business’s total debt by its total assets, using the equation:
- Total Debt / Total Assets
For example, if a company has £500,000 in debt and £1,000,000 in assets, the formula would be equated as:
- £500,000 / £1,000,000
Therefore, the company’s debt ratio would be 0.5 or 50%.
Example Of Debt Ratio
Let’s examine how the debt ratio works using a real-world example. Meta Platforms’ 2022 Form 10-K and WSJ Markets data reported the company had $14.69 billion in debt and $185.7 billion in assets.
With this information, we can calculate the debt ratio by dividing the total debt by the total assets, which gives Meta Platforms a 0.079 or 7.9% debt ratio. Therefore, Meta Platforms has an excellent debt ratio as the company doesn’t borrow from the corporate bond market and gets enough capital through stock.
Who Uses The Debt Ratio?
Dividing the total debt by the total assets isn’t the only way to determine a company’s debt position. Companies and lenders may also use financial assessments like debt to asset, debt to equity, leverage and gearing, and long-term debt to assets.
The debt ratio is used by various stakeholders in corporate financing. These can include:
- Investors: Fund managers, instituted investors, and individual investors use the debt ratio to better understand a company’s financial soundness.
- Financial Analysts: A company’s financial performance is assessed by analysts before it makes investment recommendations.
- Lenders and Creditors: Banks, creditors, and financial institutions use the debt ratio to assess an organisation’s creditworthiness and borrowing capacity before they agree to lend it money.
- Management & Executives: A company’s senior executive team will use the debtration to help them make informed financial decisions.
What Is a Good Debt Ratio?
There is no standardised “good” debt ratio, as it can fluctuate based on the nature of the industry and business. However, anything below 1.0 is generally seen as “good,” whereas a debt ratio of 2.0 or higher is likely to be considered “risky.”
However, these figures are mainly ballpark ratios. Industries like banking tend to have higher debt-to-equity ratios. This doesn’t necessarily make them risky businesses, it’s simply the nature of the industry.
Can A Debt Ratio Be Negative?
Organisations can have a negative debt ratio. This means the company has negative shareholder equity and is likely deemed “very risky” as its liabilities outnumber its assets. It could even mean that the company is at risk of going bankrupt.
Achieve Your Financial Goals With Hectocorn
The debt ratio is a critical financial assessment tool that can tell you and, more importantly, potential lenders a lot about your business. It’s vital to ensure your company doesn’t accumulate a poor or negative debt ratio, as it could impact your chances of gaining funds from investors and financial institutions.
Hectocorn is a Financial Conduct Authority (FCA) regulated debt advisory firm. Our team of expert financial advisers helps ultra-high-net-worth individuals access the most favorable financial solutions and address their financial challenges.
Discover how Hectocorn can help you achieve your financial goals by getting in touch[1] .
Link to Contact Us page
