A debt ratio is a tool used to measure the number of assets a company has acquired via debt. Investors use it to analyze the level of risk they’ll be taking by investing in a company. It also helps them evaluate how a company utilizes its debt to grow the business. A ratio bigger than one means that debts fund a significant amount of assets. A ratio of less than one shows that equity funds a huge amount of the company’s assets.
How to Calculate Debt Ratio
First, you need to understand debt ratios vary depending on the industry. Capital-intensive businesses like pipelines and utilities usually have a higher debt ratio compared to companies in the tech sector. With that said, you calculate a debt ratio by dividing total debts by total assets (Debt Ratio= Total Debt / Total Assets). Let’s say a company has total assets worth $100 million and debt of $30 million. The debt ratio will be 30% or 0.3.
But does that mean this company is better off than one with a 0.4 debt ratio? It will depend on the industry. A debt ratio of 0.3 can be considered too high if the company is in an industry where the cash flow is volatile. That’s because such companies usually take on little debt. On the other hand, a company with a debt ratio of 0.4 can be considered manageable if its industries like utilities. After all, higher debt ratios are normal, and cash flows are stable in such industries.
How Significant Is the Debt Ratio?
This ratio is useful for company officials and investors. Company officials are responsible for the company’s expansion. The debt ratio helps them see if the company has enough resources to cover its obligations. The other group is investors, who must evaluate a company’s position before investing their money. Investors have to know if a company has enough assets to pay debt expenses and other obligations. They can also assess if a company can turn bankrupt in the near future because of defaulting on its obligations.
To learn more about debt ratio, talk to the experts at Means Commercial Capital. We also offer different loan products to help you boost your business.