Debt Ratio - #1 Options Strategies Center (2024)

The debt ratio is a financial ratio that relates to the solvency levels in a company as they assess the debt to asset ratio. The debt ratio shows the company’s ability to pay off liabilities with the use of its assets. That would demonstrate the number of assets the company would have to sell to pay off the liabilities in full.

It illustrates a particular perspective concerning corporate finance, and that indicates the leverage held. The firm may be financed by debt, equity, or even both. It also considers the short and long-term assets by applying both of them within the calculation of the total assets when set against the total debt.

What the Debt Ratio Shows

The debt ratio shows the level of risk which the business has attained. The preferable thing is for a low-risk level, which means a business that is not too reliant on borrowed funds. So it would be financially stable. Businesses that have low ratios, meaning 0.5 and below, show the assets are wholly owned. Companies with high debt ratios; 0.5 and above are termed as highly leveraged.

The higher the amount of debt, the greater the risk related with a company’s operations. A low ratio indicates conventional financing with the ability to borrow in the future with limited risk.

The majority of a company’s assets are financed throughdebt rather than equity. A high debt ratio illustrates the business is in a bad financial state should the creditors decide on repayment of loans. That is the reason why lower ratios are preferred. To attain a good debt ratio, businesses need to compare their position to the industry’s average or the most significant competitors.

Formula

It is illustrated as dividing the liabilities by the total assets

Debt Ratio = Total Liabilities / Total Assets

Example

A startup has been running for six months, and they consult the bank concerning their chances of getting a new loan for expansion. The financial institution asks for the balance, so they evaluate the total levels of debt. It is discovered that the total assets number $124,000 while the liabilities are at $93,000. The debt ratio for the startup would be calculated as

$93,000/$126,000 = 0.75

That means the debt ratio is 0.75, which is highly risky. It indicates for every four assets; there are three liabilities. The startup is highly leveraged, and there is a minimal chance that the bank would award the business the loan based solely on this information. That level of debt can compromise the operation should the cash flow end. The firms that cannot service their debt can have to sell their assets and declare solvency.

Analysis

The debt ratio tends to be in decimal format as it calculates the total liabilities according to a percentage of the total assets. Similarly, as with many solvency related ratios, a lower figure would be favorable than the higher ratios. A low debt ratio means the business is stable, and there is more potential longevity because it has low levels of debt overall. Each sector has different benchmarks for the leverage, but 0.5 has been deemed as the common midpoint.

Since utility companies usually have a lot of company debt on their balance sheets, the debt ratio is useful in determining how many years of EBITDA it would take to pay back all the debt.

Lender Limits

Lenders usually have limits concerning the debt ratio above which they would not extend credit to organizations because they are overleveraged. Obviously, there are other things to consider, including payment history, professional relations, and the business’s credit. The investors, though, may rarely desire to buy company stock when there are very low debt ratios.

Should the debt ratio be at zero, it would mean that the business may not finance a lot of operations through borrowing in the first place. That means it is very risk-averse, and so there is a slow rate of return, which would be realized so the shareholders cannot depend on dividends quickly. Other ratios are better at assessing leverage, such as the debt to equity ratio, because it measures the opportunity costs.
Usually, the larger and stable organizations can push on the ledgers’ liabilities compared to the smaller firms. They also tend to have better and more robust cash flows as they can negotiate with lenders due to the economies of scale involved. The debt ratios also happen to be sensitive to interest rates.

All of the assets with interest rates have risk, whether they are loans or bonds. The same amount is costly to pay regardless of a 5 of 10% interest rate. There is a sense that the ratio analysis has to be done based on company-by-company. Balancing the dual risks of company debt and the opportunity costs is essential for all organizations.

Chris Douthit

Chris Douthit, MBA, CSPO, is a former professional trader for Goldman Sachs and the founder of OptionStrategiesInsider.com. His work, market predictions, and options strategies approach has been featured on NASDAQ, Seeking Alpha, Marketplace, and Hackernoon.

Debt Ratio - #1 Options Strategies Center (2024)

FAQs

What is a 1 debt ratio? ›

If a company's debt ratio is 1, it means that the company's total debt is equal to its total assets. Or you could say that if a company wants to repay its debt, it has to sell all its assets. If a company has to pay its debt, it has to sell all its assets, in which case the company can no longer operate.

What is the best ratio for debt ratio? ›

Do I need to worry about my debt ratio? If your debt ratio does not exceed 30%, the banks will find it excellent. Your ratio shows that if you manage your daily expenses well, you should be able to pay off your debts without worry or penalty. A debt ratio between 30% and 36% is also considered good.

What are debt ratios used to determine a company's ability to ________? ›

The debt-to-total assets ratio is primarily used to measure a company's ability to raise cash from new debt. That evaluation is made by comparing the ratio to other companies in the same industry. The higher a company's debt-to-total assets ratio, the more it is said to be leveraged.

What if debt ratio is more than 1? ›

A high debt ratio, or a ratio greater than 1, indicates that your company has more debt than assets and is at financial risk. This could mean your company won't be able to pay back its loans, debts and other financial obligations.

Is a debt ratio of 1 good? ›

Generally, a good debt ratio is around 1 to 1.5. However, the ideal debt ratio will vary depending on the industry, as some industries use more debt financing than others. Capital-intensive industries like the financial and manufacturing industries often have higher ratios that can be greater than 2.

Is a debt ratio of 2 good? ›

Although it varies from industry to industry, a debt-to-equity ratio of around 2 or 2.5 is generally considered good. This ratio tells us that for every dollar invested in the company, about 66 cents come from debt, while the other 33 cents come from the company's equity.

What is a bad debt ratio? ›

The bad debt to sales ratio represents the fraction of uncollectible accounts receivables in a year compared to total sales. For example, if a company's revenue is $100,000 and it's unable to collect $3,000, the bad debt to sales ratio is (3,000/100,000=0.03).

How do I get a better debt ratio? ›

A good debt-to-equity ratio is generally below 2.0 for most companies and industries. To lower your company's debt-to-equity ratio, you can pay down loans, increase profitability, improve inventory management and restructure debt.

What is a 3 to 1 debt ratio? ›

Example of Debt to Equity Ratio

A corporation with $1,200,000 of liabilities and $2,000,000 of stockholders' equity will have a debt to equity ratio of 0.6:1. A corporation with total liabilities of $1,200,000 and stockholders' equity of $400,000 will have a debt to equity ratio of 3:1.

What is a good debt ratio for a business? ›

Interpreting the Debt Ratio

If the ratio is over 1, a company has more debt than assets. If the ratio is below 1, the company has more assets than debt. Broadly speaking, ratios of 60% (0.6) or more are considered high, while ratios of 40% (0.4) or less are considered low.

What is a good long-term debt ratio? ›

What is a good long-term debt ratio? A long-term debt ratio of 0.5 or less is considered a good definition to indicate the safety and security of a business.

What is a good quick ratio? ›

Generally speaking, a good quick ratio is anything above 1 or 1:1. A ratio of 1:1 would mean the company has the same amount of liquid assets as current liabilities. A higher ratio indicates the company could pay off current liabilities several times over.

What if debt-to-equity ratio is 1? ›

A debt-to-equity ratio of 1 is considered to be equal, i.e. total liabilities = shareholder's equity. This ratio depends on the proportion of current and noncurrent assets because it is very industry-specific. It is said that companies with intensive capital will have a higher DE than service companies. 2.

What does it mean if debt-to-equity ratio is above 1? ›

Among similar companies, a higher D/E ratio suggests more risk, while a particularly low one may indicate that a business is not taking advantage of debt financing to expand. Investors will often modify the D/E ratio to consider only long-term debt because it carries more risk than short-term obligations.

Why are high debt ratios bad? ›

The debt-to-equity (D/E) ratio reflects a company's debt status. A high D/E ratio is considered risky for lenders and investors because it suggests that the company is financing a significant amount of its potential growth through borrowing.

What if debt to equity ratio is 1? ›

A debt-to-equity ratio of 1 is considered to be equal, i.e. total liabilities = shareholder's equity. This ratio depends on the proportion of current and noncurrent assets because it is very industry-specific. It is said that companies with intensive capital will have a higher DE than service companies. 2.

What does a debt ratio of 1.2 mean? ›

Once you've calculated the debt-to-asset ratio, you can then analyze the results. Typically, a debt-to-asset ratio of greater than one, such as 1.2, can show that a company's liabilities are higher than its assets.

What does a debt ratio of 0.5 mean? ›

Debt Ratio = 0.50, or 50%

A company that has a debt ratio at this level has a perfect balance in its debt and equity funding and would also be considered a low risk for a potential financing source.

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