What is the Debt Ratio?
The Debt Ratio is a solvency ratio used to determine the proportion of a company’s assets funded by debt rather than equity.
- What is the definition of the debt ratio?
- What formula calculates the debt ratio?
- How are the debt ratio and solvency connected?
- What does a high or low debt ratio mean?
Table of Contents
Debt Ratio Formula
The debt ratio, or “debt-to-asset ratio”, compares a company’s total debt obligations to its total assets in an effort to gauge the company’s chance of defaulting and becoming insolvent.
The two inputs for the debt ratio formula – total debt and total assets – are defined below.
- Total Debt: Short-term or long-term borrowings such as loans provided by banks, corporate bond issuances, mortgages, and any interest-bearing security with debt-like features.
- Total Assets: Resources with positive economic value, i.e. can be sold for monetary value such as cash, represents future payments from customers (i.e. accounts receivable), or be used to create future revenue like PP&E.
In order to calculate the debt ratio, the total debt of a company is divided by the total asset amount.
- Debt Ratio = Total Debt / Total Assets
For example, if a company’s debt ratio is 0.6x, there is a $0.60 in debt for each dollar of assets owned.
Debt Ratio Interpretation
All else being equal, the lower the debt ratio, the more likely the company will continue operating and remain solvent.
If hypothetically liquidated, a company with more assets than debt could still pay off its financial obligations using the proceeds from the sale.
Conversely, a company with fewer assets than debt would not have the option to do so, causing restructuring to be necessary, which could end in liquidation.
That said, the following are the general rules of thumb for interpreting the debt ratio:
- Debt Ratio < 1x: If the ratio is less than one, the company’s assets are enough to pay off all outstanding debt obligations
- Debt Ratio = 1x: If the ratio is equal to one, the company’s assets are equal to its debt, so there is clearly a large amount of leverage being used (i.e. must sell all assets to cover all outstanding debts).
- Debt Ratio > 1x: If the ratio is greater than one, the debt burden outweighs the company’s assets, which is a sign of impending financial trouble as there is no “cushion” for underperformance.
Debt Ratio by Industry
As it 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.
For example, the debt ratio of a utility company is in all likelihood going to be higher than a software company – but that does not mean that the software company is less risky.
Debt Ratio Excel Calculator
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Debt Ratio Excel Calculator
Suppose we have three companies with different debt and asset balances.
- Company A: Debt = $50 million; Assets = $50 million
- Company B: Debt = $25 million; Assets = $50 million
- Company C: Debt = $50 million; Assets = $25 million
Given those assumptions, we can input them into our debt ratio formula.
- Company A = $50 million ÷ $50 million = 1.0x
- Company B = $25 million ÷ $50 million = 0.5x
- Company C = $50 million ÷ $25 million = 2.0x
From the calculated debt ratios above, Company B appears to be the least risky considering it has the lowest ratio of the three.
On the opposite end, Company C seems to be the riskiest, as its debt balance is double the value of its assets.