Debt ratio measures a company’s ability to pay off its total liabilities with its total assets. In other words, the ratio describes how much amount (in dollars) of assets is required to pay off its total liabilities. The formula to calculate the debt ratio is:
= Total Debt / Total Assets
How It Works (Example)
Suppose, Company A has total debt of $1 million and total assets of $1.4 million, the debt ratio will be:
= $1,000,000 / 1,400,000 = 0.714
This means that each $1 of company’s assets has $0.714 of debt, the ratio above 1 indicates that the company has more debt than its assets.
The debt ratio is used to measure the financial risk of a company; the risk that the company’s total assets may not be sufficient to pay off its debt. the ratio being a critical indicator of business’ financial sustainability plays an important role while evaluation of a particular company. The debt ratio of 0.5 is considered risk free because total debts are 50 percent of total assets however the ratio above one is considered risky because debt is greater than total assets. A lower debt ratio usually describes the more stable business in the long run.