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What Is Debt Ratio? - Calculation & Overview

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  • 0:02 A Look at Debt Ratios
  • 1:02 What Is the Debt Ratio?
  • 2:13 Good and Bad Debt Ratios
  • 2:55 Examples
  • 4:55 Lesson Summary
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Lesson Transcript
Instructor: Rebekiah Hill

Rebekiah has taught college accounting and has a master's in both management and business.

In this lesson, you'll learn what a debt ratio is in accounting. You will also learn how to calculate a company's debt ratio and why it is important to financers and investors.

A Look at Debt Ratios

Have you ever been to a car dealership to buy a car? If so, then you know that picking out the car is the easy part. All the paperwork that is involved in the buying process can seem to take forever! Potential financers want to know two key things. First and foremost, they want to know how much money that you make. Second, they want to know how much money that you pay out on bills.

Why do you think that they want to know these things? The answer is quite simple. They want to know if you'll be able to pay for the car once you get it. If you have more bills than you have money coming in, then you are not a good candidate for a new car loan. However, if your money coming in each month is greater than the total of all the bills that you owe in a month, then you are exactly what the potential financer is looking for and will more than likely be approved for your loan.

This is the exact scenario that organizations face when seeking financing on new or existing projects. Financial institutions and potential investors rely heavily on something called the debt ratio.

What Is the Debt Ratio?

In the business world, the term debt ratio refers to the amount of assets that an organization has in relation to the amount of liabilities. Assets are things that a business owns and uses to produce an income. Liabilities are what the business owes. The debt ratio shows how much a company relies on debt to finance company assets. The total liabilities and total assets values can be found on the company's balance sheet. The formula for calculating the debt ratio is:

Debt Ratio = Total Liabilities / Total Assets

Another common term that is seen when discussing the debt ratio is the term equity. In the accounting sense, the term equity is used to describe the funding that an organization gets from selling shares of stock. Selling stock to raise money is different than taking out a bank loan. When a company offers shares of stock for sale, it is allowing people to make investments and become partial owners in the company. In return for the stock purchase, the company may also agree to pay the investor a certain percentage of any yearly profit. This percentage is called a dividend. If the company doesn't make any money, then the shareholder will make no money. Funding received by sales of stock is called equity funding.

Good and Bad Debt Ratios

In an ideal world, a company would have a debt ratio of 0.5, or 50%. This would mean that the company was funded equally by debt and equity funding. If this company were to decide to seek additional funding for a project from a bank, the bank would look favorably on this debt ratio. Let's say that the company had a debt ratio of 0.3, or 30%. With this debt ratio, the bank would consider the company low risk and would jump at the chance to loan it money. What if the debt ratio was much higher, like 0.8, or 80%? A debt ratio this high would throw up a red flag to the bank. At this level, the company would appear to have most of their assets funded by debt and would be a high risk for the bank.

Examples

Let's take a minute to look at a few examples of calculating debt ratio.

Example 1

XYZ Corporation's balance sheet shows a total asset value of $350,000. The total liabilities shown on the balance sheet are $125,000. What is the debt ratio?

Debt Ratio = Total Liabilities / Total Assets

Debt Ratio = $125,000 / $350,000

Debt Ratio = 0.36, or 36%

XYZ has a low debt ratio and would be a low risk for a potential financing source.

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