Your debt ratio shows how your company’s debts compare to its total assets. It’s a measure of your financial leverage, or how much you rely on debt to cover the costs of doing business. Your debt ratio changes over time because you might pay off debts, take on more debt, increase assets or lose assets.
Calculating Debt Ratio
Calculating your company’s debt ratio requires you to know the total amount of your debts and your assets. Add up all of the debts of your business, including long-term and short-term debts. You want to include all of your debt, because including only your current debt doesn’t give you an accurate number. Divide your total debt by the total assets of your business.
This example shows the debt ratio in action:
- Imagine your business has $500,000 in total liabilities and $1.5 million in total assets.
- Divide $500,000 by $1.5 million.
- The calculation equals 0.33, which is your debt ratio.
If your debt ratio is one, that means your assets and liabilities are equal, which isn’t a healthy financial situation in which to find yourself. At a debt ratio of one, you’d need to sell all of your assets to pay your debts, which leaves you with no way to continue operating.
Why Does Your Debt Ratio Matter?
For your own benefit, debt ratio is a measure that can help you see if your liabilities are high compared to your assets. It’s a quick way to see how easily you could pay off your debts. If you’re looking for investors or additional financing, your debt ratio can come into play in their decision. A high debt ratio shows that you have a large amount of debts compared to your assets, which generally comes with increased financial risk. A lower debt ratio shows that lending to you comes with a decreased risk because you have the ability to pay off debts more easily than a company with a higher debt ratio.
Some industries, such as telecommunications, auto, utilities and manufacturing, tend to have high debt ratios because the businesses in these industries require more capital to run than businesses in other industries. When using the debt ratio as a measure of your company’s financial health, it’s best to compare the ratios within your industry to see how you compare to similar businesses.
Calculating your debt ratio is easier when you track your assets and liabilities accurately. 4.3 million customers use QuickBooks. Join them today to help your business thrive for free.