Debt Ratio Definition, Components, Formula, Types, Pros & Cons

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. Capital leases listed on the balance sheet are in short-term and long-term debt. The total assets include goodwill, intangibles, and cash, encompassing all assets listed on the balance sheet at the analyst’s or investor’s discretion.

We may earn a commission when you click on a link or make a purchase through the links on our site. All of our content is based on objective analysis, and the opinions are our own. Readyratios.com has a chart outlining the industry medians over the last five years, which is a great resource for can you claim your dog on your taxes finding the median for the industry you are analyzing and comparing your company. A simple rule regarding the debt-to-asset ratio is that the higher the ratio, the higher the leverage. The debt-to-asset ratio measures that debt level and assesses how impactful that might be for any company. A balanced capital structure often indicates sound financial management and strategic thinking about the cost of capital.

Debt Ratio Formula

This assessment can be particularly vital for creditors, investors, and other stakeholders when evaluating the financial health of an organization. A lower debt ratio often suggests that a company has a strong equity base, making it less vulnerable to economic downturns or financial stress. The debt ratio offers stakeholders a quick snapshot of a company’s financial stability. In contrast, companies looking to expand or diversify might again increase borrowing, potentially raising the ratio.

This is because a 0% ratio means that the firm never borrows to finance increased operations, which limits the total return that can be realized and passed on to shareholders. The total debt-to-total-asset ratio is calculated by dividing a company’s total debts by its total assets. 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. This tells you that 40.7% of your firm is financed by debt financing and 59.3% of your firm’s assets are financed by your investors or by equity financing. The debt ratio focuses exclusively on the relationship between total debt and total assets. However, companies might have other significant non-debt liabilities, such as pension obligations or lease commitments.

1. This ratio provides a snapshot of a company’s short-term liquidity and its ability to meet immediate financial obligations using its most liquid assets.
2. Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader.
3. A ratio higher than one indicates that most of the company’s assets funding comes from debt and that a higher debt load carries a higher risk of default.
4. We can use the debt-to-asset ratio to measure the amount or percentage of debts to assets.
5. For example, in the example above, say XYZ reported $2.9 billion in intangible assets, $1.3 billion in PPE, and $1.04 billion in goodwill as part of its total $20.9 billion of assets.

How Do You Calculate the Debt Ratio?

Such comparisons enable stakeholders to make informed decisions about investment or credit opportunities. Our goal is to deliver the most understandable and comprehensive explanations of financial topics using simple writing complemented by helpful graphics and animation videos. Pete Rathburn is a copy editor and fact-checker with expertise in economics and personal finance and over twenty years of experience in the classroom. A company with a high degree of leverage may thus find it more difficult to stay afloat during a recession than one with low leverage. As always, thank you for taking the time to read today’s post, and I hope you find some value in your investing journey.

The lower debt-to-asset ratio also signifies a better credit rating because, as with personal credit, the less debt you carry, the more it helps your credit rating. Let’s look at a few companies from unrelated industries to understand how the ratio works to put this into practice. Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI’s full course catalog and accredited Certification Programs. A company with a lower proportion of debt as a funding source is said to have low leverage. A company with a higher proportion of debt as a funding source is said to have high leverage.

What Are Some Common Debt Ratios?

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Examples of the Debt Ratio

The debt ratio is the ratio of a company’s debts to its assets, arrived at by dividing the sum of all its liabilities by the sum of all its assets. If you’re wondering how to calculate your debt-to-asset ratio, it’s actually a lot easier than you may think. All you’ll need is a current balance sheet that displays your asset and liability totals. Calculating your business’s debt-to-asset ratio can provide interested parties with the numbers they need to make a decision on investing in or loaning funds to your company.

Two companies with similar debt ratios might have significantly different interest obligations, impacting their overall financial performance and risk. By examining a company’s debt ratio, analysts and investors can gauge its financial risk relative to peers or industry averages. Newer businesses or startups might rely heavily on debt financing to kick-start operations, leading to higher debt ratios. This can include long-term obligations, such as mortgages or other loans, and short-term debt like revolving credit lines and accounts payable. Financial data providers calculate it using only long-term and short-term debt (including current portions of long-term debt), excluding liabilities such as accounts payable, negative goodwill, and others.

Looking at the raw number on the balance sheet won’t tell you much without context. It is a great practice to analyze the debt using the above ratios and read through the debt covenants to understand each company’s debt situation. To find relevant meaning in the ratio result, compare it with other years of ratio data for your firm using trend analysis or time-series analysis. Trend analysis is looking at the data from the firm’s balance sheet for several time periods and determining if the debt-to-asset ratio is increasing, decreasing, or staying the same.

It indicates how much debt is used to carry a firm’s assets, and how those assets might be used to service that debt. The higher the ratio, the more leveraged the company and riskier the investment. Our first guinea pig will be Microsoft (MSFT), and we will use the latest 10-k to calculate the numbers. I will screenshot the company’s balance sheet and highlight the inputs for our ratio. The debt covenant rules regarding the debt and the repayment of the debt plus interest; if the company fails to make its debt payments, it risks defaulting on its loan, leading to bankruptcy. As we analyze each company, we can use the debt-to-asset ratio to analyze how much debt a company carries, its ability to repay that debt, and its likelihood of taking on additional debt.

It’s great to compare debt ratios across companies; however, capital intensity and debt needs vary widely across sectors. The financial health of a firm may not be accurately represented by comparing debt ratios across industries. Bear in mind how certain industries may necessitate higher debt ratios due to the initial investment needed. The debt to total assets ratio describes how much of a company’s assets are financed through debt.

The total debt-to-total assets formula is the quotient of total debt divided by total assets. As shown below, total debt includes both short-term and long-term liabilities. As with any ratio analysis, it is a great idea to analyze the ratio over a while; five years is great, and ten years is even better. Looking at longer periods helps analysts assess the company’s risk profile and improve or worsen. Typically, the lower the ratio, the better, but as we saw with our analysis of the above companies, each industry carries different debt loads. Across the board, companies use more debt financing than ever, mainly because the interest rates remain so low that raising debt is a cheap way to finance different projects.