We are sure you have heard about the word debt a lot of times in your life. But have you ever heard of the debt ratio? Debt ratio is considered a financial metric that is very important in a company as it allows them to know the total debt and the assets that the company owns.

If you are not aware of what debt ratio is or how it works, then you have clicked on the right page. Here, we have discussed everything that you need to know about this concept. So, let's get into the article and see all the little details related to it.

What is the Debt Ratio?

The first thing that you need to know is what the debt ratio is. This is a way through which the company can know the leverage they have. This means that with the help of this method, the company can compare its debts with its assets. There are different variants of the debt ratio that show the comparison between the liabilities and the equity in a company. You can use this formula to calculate if your company is able to pay off its debts and liabilities with the assets they own.

This is an important concept that every business owner needs to understand. With the help of this calculation, the company can make a lot of significant decisions, and it is a way through which an organization can attract more investors and lenders.

The debt ratio is also excellent for the companies as it helps them determine whether the company is financially stable or not. This is an essential tool that is now being used by a lot of companies all over the world to determine working and financial health.

When we are talking about the debt ratio, you should understand that if the ratio is higher than 1, then this means that the assets of the company are found with the debts. It means that the company has more liabilities as compared to the assets. When you are getting a high ratio, this will indicate that the company needs to keep a check on its debts. They can be at risk of default on the loans if the rates increase suddenly.

However, suppose the ratio is lower than 1. In that case, this means that the financial condition of the company is extreme, and the more significant portion of the assets is funded by equity. Hence, when you are doing the debt ratio, you need to make sure that the ratio is always lower than 1.

Formula of Debt Ratio:

The next thing that you should know regarding the debt ratio is the formula and how to calculate this ratio. As we talked about above, the debt ratio is the measurement of the extent of the financial leverage that the company has. This debt ratio can vary from the industry, and each industry can have a different ratio.

Below is the formula that you need for the calculation of the ratio.

Debt ratio = Total Debt/Total Assets

In order to better understand how to calculate this debt ratio, let us discuss one example. For example, one company has total assets worth $100 million, and the debt that this company has is about $30 million. When you use the formula mentioned above, you will get the value 0.3 or 30%. Now the question comes: is this a good value for a company?

This depends on the industry and the type of company that is using this formula. If your company deals with a volatile cash flow, then the 30% debt ratio can be a lot. This is because, in such companies, the debt is minimal. However, if the company is in the utility sector, then this means that the 30% value of the debt ratio can work fine, and it won't hurt the assets of the company.

Advantages and Disadvantages of Debt Ratio:

Now that you know what the debt ratio is and the formula that is used to calculate this ratio, it is time for you to see some of the pros and cons of using this concept.

Advantages of Debt Ratio:

The following are some of the significant advantages that a company can have if they use the formula in their financial sector.

• With the help of the debt ratio, the company can have a quick overview of its financial status.
• It helps in understanding the liabilities and the assets the company owns.
• The debt ratio also helps determine if the company is able to cater to the long-term debt commitment.
• Investors can use the information from the debt ratio to make more calculated and informed investment decisions.
• This is also good for offering comparison points between two companies working in the same industry. It is suitable for investors to know which company is a better option for investment and which company is financially stable.

Disadvantages of Debt Ratio:

With everything, there are some disadvantages as well. If you are wondering what the disadvantages of this are, then we have mentioned a few below.

• It is not suitable for revealing the type of debt your company is facing or even the cost of the debt.
• The debt ratio is not good as it does not take the company's profitability into account.
• The debt ratio only tells the financial health of the company at a particular moment in time. However, there are a lot of factors that can change it all the time.

Final Words:

A debt ratio is a tool through which the company can understand its debts and liabilities. This is a way through which the companies can also have a better picture of their financial situation. However, businesses need to understand if they have a higher debt ratio, then they need to change the strategy of their company and make sure they look into their debt. We hope this article was helpful for you in learning more about this concept.