The debt ratio is a financial leverage ratio that measures the portion of company resources (pertaining to assets) that is funded by debt (pertaining to liabilities). A company with a high debt ratio is known as a “leveraged” firm.
The debt ratio can be computed using this formula:
|Debt ratio||=||Total liabilities|
Both figures can be obtained from the balance sheet.
Now, since total assets come from two sources -- debt and equity, the portion that is not funded by equity is naturally the portion funded by debt. Hence, as an alternative we can use the following formula:
Debt ratio = 1 – Equity ratio
The following figures have been obtained from the balance sheet of XYL Company.
|Total liabilities and equity||15,600,000|
The above figures will provide us with a debt ratio of 73.59%, computed as follows:
|Debt ratio||=||Debt / Assets|
|=||11,480 / 15,600|
Alternatively, if we know the equity ratio we can easily compute for the debt ratio by subtracting it from 1 or 100%. Equity ratio is equal to 26.41% (equity of 4,120 divided by assets of 15,600). Using the equity ratio, we can compute for the company’s debt ratio.
|Debt ratio||=||1 - Equity ratio|
|=||1 - .2641|
|=||.7359 or 73.59%|
The debt ratio is a measure of financial leverage. A company that has a debt ratio of more than 50% is known as a "leveraged" company. Its debt ratio is higher than its equity ratio. It means that the business uses more of debt to fuel its funding. In other words, it leverages on outside sources of financing. In the above example, XYL is a leveraged company.
Companies with lower debt ratios and higher equity ratios are known as "conservative" companies.
Leveraged companies are considered riskier since businesses are contractually obliged to pay interests on debts regardless of their operating results. Even if a business incurs operating losses, it still is required to meet fixed interest obligations. In contrast, the payment of dividends to equity holders is not mandatory; it is made only upon the decision of the company’s board. Hence, leveraged companies are more risky.
The debt ratio is another measure of leverage. The higher the debt ratio, the riskier the position of the company is. Debt is considered riskier compared to equity since they incur interest, regardless of whether the company made income or not.