What is a Debt Ratio?

A. Gabrenas
A. Gabrenas
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Businessman giving a thumbs-up

A debt ratio is a type of financial ratio that helps calculate the amount what a company owes compared to the value of its assets. It’s a tool that is often used in determining the health of a company and its ability to repay debt over the long term. There is also a type of consumer debt ratio, more commonly known as a debt-to-income ratio, that works similarly to show the financial health of an individual.

To calculate a company’s debt ratio, access to the balance sheet is typically needed. The balance sheet will generally show, amongst other things, how much the company owes in debts and the current value of its assets. Debt ratio can then be determined by dividing the total debt by the total assets. In general, the higher the result, the more the company is relying on credit to operate. If the result is greater than one, that typically means the company actually has more debt than assets.

One instance in which a company’s debt ratio may be evaluated is when a company seeks a loan. In this case, the lender will often look at this ratio to help determine how likely it is that the company will be able to pay back the loan. Experts generally agree that the higher a company’s debt ratio, the greater risk it has of defaulting on a loan. Conversely, the lower the ratio, the more likely the company will typically be able to pay back the loan as agreed.

Due to the fact that higher debt ratios often correlate to greater risk for the lender, companies with high debt ratios often have to pay increased interest rates when borrowing money. In some cases, if a debt ratios are too high, companies may not be able to borrow money at all. Such situations generally require the affected companies to seek additional assets.

In addition to debt ratio showing the health of a company, it can also help show the financial health of an individual. Personal debt ratios, or debt-to-income ratios, are often used to determine how likely individuals will be able to pay back loans. To calculate this, one must add up all of an individual’s fixed monthly expenses, such as mortgage payment, homeowner’s insurance, property taxes, credit card payments and other regular loan payments. This amount is then divided by the person’s monthly pre-tax income.

For this calculation, in general, the lower the ratio, the less debt a person has and the more likely he or she will be able to pay back a loan. Lenders typically set specific guidelines for these ratios in determining whether a person is offered a loan. For example, for mortgages in the United States, most lenders require applicants to have a debt ratio of 36% or less. As with companies, the higher a person’s debt ratio, the more trouble he or she may have finding suitable loan terms.

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