Debt Management Ratio
Debt ratio is the financial ratio that measures the company debt to total assets. It measures how much the company uses debt to support its operation compare to other sources of finance such as share equity and retaining earning. Company can raise capital from both debt and equity. Debt is the amount that the company borrows from bank or creditor, company has obligation to pay back the principle and interest base on schedule. Equity is the amount belongs to the owner or shareholders.
If the ratio is greater than one, it means the entity is significantly funded by debt. Debt balance even higher than total assets. If the ratio less than 100%, it means some portion of the assets is funded by the equity.
Investors and creditors interest in this ratio very much as it will show the company financial leverage. A higher debt ratio means company is in a high-risk position which requires huge cash flow in both short term and long term. Failure to pay the debt, the company is going to face liquidation as the creditors require to pay cash. Unlike debt, the company does not require to pay to shareholders, it is the benefit of equity capital.
Debt Ratio Formula
In order to calculate the debt ratio, we need to have the company balance sheet which
|Debt Ratio = Total Debt / Total Assets
- Total Debt: the amount of debt that company owe to bank and creditor
- Total Assets: the average total assets of the company. If data is not avaiable, we may use closing balance.
Example of Debt Ratio
Based on the financial statement, ABC Co., Ltd has total assets of $ 50 million and Total debt of $ 30 million. Please calculate the debt ratio.
Debt Ratio = $ 30 millions / $ 50 millions = 60%
It means that 60% of ABC’s total assets are funded by debt. The remaining 40% of total assets funded by equity or investors fund.
We can benchmark by comparing this ratio with the industry average to analyze the company risk toward financial leverage.