Understanding the Debt Ratio

Most of my recent postings have concerned how businesses are financed and how to measure the returns on those investments. Understanding the debt ratio will help you better understand the financing of a business.

What is the Debt Ratio?

The formula for calculating the debt ratio is:

Debt Ratio = Total Liabilities / Total Assets

(Note that this is expressed as a percentage)

Using a sample balance sheet from an earlier posting, let’s see that calculation.

what is debt

In the above example, the debt ratio calculation would be:

Debt Ratio = Total Liabilities / Total Assets

Debt Ratio = ($966,000 + $400,000) / $2,003,575

Debt Ratio = 68.2%

As you can see, this company is obtaining 68.2% of its financing via some form of debt obligation, whether it be accounts payable, sales tax payable, income tax payable, and accrued expenses or debt issued in the form of interest bearing obligations (Here interest bearing obligations include both the Current and Long-Term Portions of Long-Term Debt). See What is Debt Really? for a discussion of what is considered debt for official purposes.

Some Interpretation

The accounts payable, sales tax payable, income tax payable, and accrued expenses included in the above calculation are operational debt, so to some extent the debt ratio is a little distorted. These liabilities are associated more with daily operations, while both the current and long-term portion of long-term debt are used primarily for buying things that will be used over a number of years, such as equipment.

Regardless of this distinction, the above company is relying heavily on debt leverage to both operate daily and to grow.

When you analyze your company balance sheet are you comfortable with the level of debt you are carrying? Will a downturn in business make it difficult to meet your debt obligations? The debt ratio is a great way to evaluate this.

If you want to know more, contact AimCFO – Contact

As always, your comments are welcomed.

Share

Leave a Reply

Enter your email address:

Delivered by FeedBurner