Next video:
Loading the player...

The debt ratio divides a company’s total debt by its total assets to show how highly-leveraged the company is—in other words, how much of its assets are financed by debt. The debt component of the ratio includes both traditional debt and operational liabilities, such as accounts payable and taxes payable. Usually, the lower the debt ratio the better, but the acceptable debt ratio varies by industry and the stage of the company's life. A high debt ratio might also be more acceptable if the company is large and well established. 

Energy or Electric companies require lots of capital to fund and develop operations, which usually translates into having have high debt ratios. They also have the regular income of their customers' monthly payments, which reduces risk otherwise associated with a high debt ratio. Most other companies require less debt to operate and expand, and will tend to have lower debt ratios. It is important for investors to compare the debt ratio between peer companies, or an industry benchmark, in order to obtain a clear picture of the companies' health. Comparing debt ratios from a tech company to a goods company might not give an accurate depiction of their respective health. 

If the industry benchmark for technology companies is a debt ratio of 20%, an investor might not want to invest in a tech company with $500 million in assets and $200 million in debt. This 40% debt ratio would mean the company has taken on too much debt, and is likely a risky investment. However, the same ratio might be acceptable for investing in an electric company, whose industry has a benchmark ratio of around 37%. 

Debt ratios can also apply to consumers. They are calculated when a consumer wants to take out a loan, such as a mortgage or car loan. Suppose Steven wants to buy a house and the monthly mortgage payment would be $2,000. His monthly income is $6,000. Steven’s other debts include $500 per month in student loans and $300 per month for his car payment. Including the proposed mortgage payment, Steven’s total debt ratio is ($2,000+$500+$300)/$6,000. This equals a debt ratio of 46.67%. With such a high debt ratio, he would probably be rejected by the bank and not be approved for a mortgage unless he bought a less expensive house.

Related Articles
  1. Investing

    Debt Ratios

    Learn about the debt ratio, debt-equity ratio, capitalization ratio, interest coverage ratio and the cash flow to debt ratio.
  2. Investing

    Understanding Leverage Ratios

    Large amounts of debt can cause businesses to become less competitive and, in some cases, lead to default. To lower their risk, investors use a variety of leverage ratios - including the debt, ...
  3. Investing

    4 Leverage Ratios Used In Evaluating Energy Firms

    These four leverage ratios can help investors evaluate how energy manage their debt.
  4. Investing

    Analyzing General Electric's Debt Ratios in 2016 (GE)

    Evaluate GE's debt picture using the most important metrics for a large-cap conglomerate, including the debt-to-equity (D/E) ratio and the interest coverage ratio.
  5. Investing

    Debt Reckoning

    Learn about debt ratios and how to use them to assess a company's financial health. You could save a lot of money!
  6. Investing

    Analyze Investments Quickly With Ratios

    Make informed decisions about your investments with these easy equations.
  7. Investing

    Analyzing Wal-Mart's Debt Ratios in 2016 (WMT)

    Analyze Wal-Mart's debt-to-equity ratio, interest coverage ratio and cash flow-to-debt ratio to evaluate the company's financial health and debt management.
Hot Definitions
  1. Ethereum

    Ethereum is a decentralized software platform that enables SmartContracts and Distributed Applications (ĐApps) to be built ...
  2. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
  3. Financial Industry Regulatory Authority - FINRA

    A regulatory body created after the merger of the National Association of Securities Dealers and the New York Stock Exchange's ...
  4. Initial Public Offering - IPO

    The first sale of stock by a private company to the public. IPOs are often issued by companies seeking the capital to expand ...
  5. Cost of Goods Sold - COGS

    Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold in a company.
  6. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and expenses incurred during a specified period of time, usually ...
Trading Center