All About Mortgages: What are Debt Ratios?

WHAT ARE DEBT RATIOS

Lenders want to reduce risk as much as possible. One of the methods they use to demonstrate that an applicant is good to lend to is through the debt ratio formula.

In this article we will cover the following topics:

What is the debt ratio?

Debt ratio is a type of financial ratio that can be used to describe the level of a firm’s leverage. Debt ratio is also known as debt to total asset ratio or debt to asset ratio. The debt ratio of a company measures its financial health and it determines whether it can pay its liabilities with its assets.

Usually, lenders and investors use the financial statements of a company to calculate its debt ratio to measure its financial leverage and its ability to meet the debt obligation in the future. It gives insight into how company assets are financed— either through debt, equity, or a combination of both.

If the level of liability is high compared to assets, then the company is considered highly leveraged. This is because the business tends to finance its operations and assets through debt. Such a company is riskier for creditors and investors and may struggle to borrow money.

Why Debt Ratio Matters?

Most people wonder what debt ratios are and why they matter. The debt ratio measures the degree of leverage of a company and this is used by investors and lenders to measure risk. It helps lenders to estimate the level of lending risk that they will incur when they give corporate finance to companies and organizations.

When applying for loans, most lenders will want to know what the debt ratios for your business are. Every lender wants to give credit to a company with a low debt ratio, as this shows that their overall debt burden is low. A low-risk debt ratio also means that the business is more independent and doesn’t only rely on borrowed funds. However, a high debt ratio shows that the company will go out of operation should the creditors require full repayment of the debt.

Debt ratios are also important to investors as it helps them determine the financial leverage of a business before they can make any investments. When a business provides for its assets through debt, creditors consider the business as credit risky and investors tend to shy away. Basically, the higher the debt ratio the greater the financial leverage and risk of a company. When investors buy businesses with a high ratio, it means that they may take on more debt. This can lead to more challenges for investors in the future.

What is the Debt Ratio Formula?

The debt ratio of a company is calculated by total liabilities divided by the total assets. It’s important to note that the debt comprises both short term and long-term liabilities while the total assets include the company’s intangible, current, and fixed assets. The formula is:

Debt Ratio = Total Liabilities / Total Assets

Higher debt ratios show that the company financing to pay off assets is from debt rather than equity, and this is a risky financial approach.  On the other hand, a lower debt ratio implies that the company financing comes from equity and not debt. Creditors, investors, and lenders are more likely to lend to borrowers with low debt ratios because they have a higher ability to pay off in the future.

Analysis of Debt Ratios

The debt ratio is an important financial ratio to lenders and creditors. Basically, different lenders set their own debt ratio limits that they use to determine whether a company has good financial health. Ratio analysis also gives them insight into the company’s ability to repay the debt in full.

A debt ratio (0.5 or lower) is considered a good debt since it shows that the company’s assets are financed via equity. In simple terms, a company with a debt ratio of 0.5 has assets that are twice as much as the liabilities. 50 percent of the company’s assets are owned by the shareholders while the other 50 percent are owned by creditors. If the company decided to sell all its assets, they would have enough to pay off the debt and remain with a good amount of money.

A debt ratio of 0.6 or higher is considered a high debt ratio, and such companies are considered highly leveraged. A debt ratio above 1.0 implies that the company in question has more debts than assets. To pay off their liabilities, the company would have to sell all its assets, and they would be left with nothing, leading to bankruptcy. Such companies are risky for potential investors.

Example:

Company ABC is considering borrowing money from the local bank. The bank then looks at the company’s financial statement to determine what are the debt ratios of the company. The bank finds out that the company has total assets of $100,000 as well as debt outstanding of $25,000 on its balance sheet. To find the company’s debt ratio, we divide the total liabilities by the total assets:

Debt ratio = $25,000/ $100,000

= 0.25

The low debt ratio shows that most of company ABC’s assets are provided through equity and only 25 percent are financed through debt.  It is, therefore, easier for this company to borrow money.

Risks of Low Debt Ratio

Although low credit shows a company’s creditworthiness, there are risks associated with having very little debt. Some investors shy away from purchasing stock from companies with very low debt ratio. This is because firms with very low debt ratio do not consider borrowing as an option to finance and expand their operations. As a result, they may not bring in as many returns as investors would want. You might want to take this into consideration if you want investors to purchase stock in your firm.

Leveraging Financial Strength

It is also important to note that different industries have varying debt ratios. The type of industry also affects how the debt will be used. For instance, businesses in the capital-intensive industry such as pipelines, manufacturing, and utilities have higher debt ratios compared to those in the technology sector and other industries.

This means that a company in the sector of pipeline or utility with stable cash flows can be able to manage when it has more debts than assets. Because a high debt ratio is a norm for such an industry, they are more likely to get away with high indebtedness than other sectors. Therefore, when calculating the optimal debt ratio of a company, it is paramount to consider the industry and do a comparison with the competitors.

The other thing that can be used to determine whether a company is in a good financial situation is the company’s cash flow. Large companies can leverage financial strength because they tend to have more stable cash flows than smaller companies. Also, businesses in monopoly and oligopoly are subject to reliable and steady cash flows and can repay the loan in a reliable manner.

Conversely, smaller businesses are subject to unpredictable cash flow because of rapid product cycles and constant competition. Because of their volatile cash flows, smaller businesses may find a debt level of 30% to be too high, something that can be manageable for companies with stable cash flows. Thus, companies in industries that experience unstable cash flow should maintain a low ratio of total debt.

Debt Ratio and Interest Rates

Whether a debt ratio is good or not will also depend on the current interest rate. Debt ratios are prone to interest rate risk. Essentially, when the interest rates are high, good debts are relatively lower than when the interest rates are low.

A company that has a high debt ratio has more debts, and this command a significant amount of the company’s cash flow in terms of principal and interest rate payments. Consequently, the company is likely to default in making payments when the interest rate increases.

Conversely, a low debt ratio shows that the company’s assets are more than its debts. Such a company is not very sensitive to changes in interest rates. For this reason, the principle and interest payment won’t take much of the company’s cash flow. A slowdown in the financial performance won’t necessarily lead to a default in debt payment. It is therefore important that the risk of debt ratio be analyzed on a company-to-company basis.

What Is the Difference Between Debt Ratio and Long-Term Debt to Asset Ratio?

The Debt ratio which is calculated as total debts divided by total assets considers both long-term debts like mortgages and short-term debts like, loans, lines of credit, and rent. On the other hand, the long-term debt to asset ratio is calculated by including only long-term debts like securities and mortgages.

Nonetheless, both ratios include all the assets of a business, including tangible assets like property, inventory and equipment as well as intangible assets like goodwill, and accounts receivable. All the same, the debt ratio is likely to be higher than the long term debt to assets ratio because it compromises more of the company’s liabilities.

Final Thoughts on What are Debt Ratios?

If you are managing your own company, you need to diligently keep records of your financial businesses. This will help you estimate your business’ debt ratio so that you can avoid being in a risky financial structure.

With a low debt ratio, creditors will approve your loan application and investors will not shy from buying your business. You can also take advantage of accounting and invoicing software like Debtor to track your assets so that you know what are debt ratios for your company.

This page may contain affiliate links. This website may contain content that comes from Amazon. This website and its pages are not intended to constitute legal, financial, or tax advice. The information on this website and its pages are not intended to constitute investment advice and all content are the views and opinions of the author(s), contributors, or administrators. Please read our disclaimer for more info.

Hi. My Name is

James Gheen

Welcome to the Bigger Investing website. I’m here to help you find the resources, motivation, and guidance for all entrepreneurial, investing, business, career endeavors, and more, so that you can invest in what’s most important. Your mind!

My focus is to equip you with expert sources, books, guides, articles, and more to help you achieve your personal goals.

Want to learn more? Take a look.

getabstract ad


Read in Graphics

Rich Dad Summit Ad

Best Books on Technology Industry

Best Books on Technology Industry

echnology in our society is something that helps us in many ways. It has changed the way we work, communicate, do business, and even how we learn. This blog post will provide you with a list of some great books on the technology industry to help...

What Businesses Use Telemarketing?

What Businesses Use Telemarketing?

elemarketing is a marketing technique that has been in use since the 1930s. It was developed to help businesses and individuals reach out to customers and potential clients by phone. Businesses of all sizes can benefit from telemarketing, but...

How Do I Start a Telemarketing Business?

How Do I Start a Telemarketing Business?

fter you have thought about the potential of a telemarketing business and decided it is for you, there are many steps to take before launching your company. First, find an office space that will suit your needs and then start looking for...

Best Books on Telemarketing

Best Books on Telemarketing

he most important part of a telemarketing campaign is the initial contact. This is where you make your pitch, and to do this effectively, you need to know what script to use. A good book on telemarketing will guide you through every step of the...

What are the Seven Rules of Negotiation?

What are the Seven Rules of Negotiation?

egotiation is a crucial skill to have in any business. It can be used not only with clients but also internally to get the best terms for your company and employees. While there are many different ways to negotiate, some of the most important...

What are Good Negotiation Skills?

What are Good Negotiation Skills?

he ability to negotiate is one of the most essential skills that a person can have. Negotiation is not only important in business, but it's also an important skill in life. The way you negotiate will determine your future success and happiness. A...

What is the Key to Successful Negotiation?

What is the Key to Successful Negotiation?

here are certain things you should never do in a negotiation. When I was just starting out, these were some of the most difficult lessons for me to learn. If you want to be successful at negotiating, there are three basic principles that will help...

How Do You Counter Offer a Salary?

How Do You Counter Offer a Salary?

t can be really difficult to counter offer a salary. When it comes down to it, you want the job and they want you. So how do you turn this situation into an advantageous one? The first thing is to know what your worth is. It may seem like a...

How Do You Start a Negotiation?

How Do You Start a Negotiation?

here are many ways to start a negotiation, but you need to keep in mind that the person on the other side of the table is just as nervous and scared about it as you are. You can make them feel more comfortable by starting with an ice breaker...

What Makes a Good Sales Negotiator?

What Makes a Good Sales Negotiator?

f you're in the market for a good sales negotiator, it's important to know what makes somebody successful at this job. First of all, they have to be able to negotiate well and get their clients the best deal possible. They also need to understand...

What is a Lettings Negotiator’s Salary?

What is a Lettings Negotiator’s Salary?

hat is a lettings negotiator's salary? This question should be on the mind of any prospective rental tenant. The negotiation process can be confusing, and knowing what to expect can help make it less stressful. The first thing to consider is that...

How Do You Deal with a Hard Negotiator?

How Do You Deal with a Hard Negotiator?

f you want to successfully negotiate a deal, it's important that you know how to handle someone who is hard-headed. These people are difficult and will not budge on their prices or demands. In this blog post, we'll discuss strategies for dealing...

What is the Most Important Attribute of a Negotiator?

What is the Most Important Attribute of a Negotiator?

negotiator is someone who helps two parties reach an agreement. What are the most important skills needed for this job? The answer to that question depends on what type of negotiation you're doing. In a business negotiation, it's important to be...

What Are the Characteristics of a Good Negotiator?

What Are the Characteristics of a Good Negotiator?

good negotiator is someone who has the ability to manage their emotions and think strategically. They are also able to communicate well with others, which can lead to building stronger relationships that could be beneficial in future negotiations....

What Country Has the Lowest Capital Gains Tax?

What Country Has the Lowest Capital Gains Tax?

he United States has one of the highest capital gains taxes in the world. It's a whopping 39% on long-term capital gains and 20% on short-term capital gains. If you're looking for a country with lower tax rates, look no further than Estonia. The...

Are There Any Tax Shelters Left?

Are There Any Tax Shelters Left?

here are many different tax shelters, and some of them are more popular than others. One of the most popular is a retirement account such as an IRA or 401k, but there are other options out there. In this blog post, we will explore these...

How Do Billionaires Avoid Taxes?

How Do Billionaires Avoid Taxes?

illionaires have a lot of money and they don't want to pay taxes on it. That seems pretty simple, right? In reality, their tax avoidance is more complex than you might expect. We're going to take a look at the different strategies that...

How Do Tax Havens Make Money?

How Do Tax Havens Make Money?

ax havens are a hot topic these days. They make money by helping businesses, wealthy individuals, and other investors keep their money away from the taxman. This is done in a variety of ways including bank secrecy laws that limit the amount of...

What is Called a Tax Haven?

What is Called a Tax Haven?

tax haven is a country or territory that offers favorable tax rates to foreign individuals, corporations, and other business entities. Tax havens can be either onshore or offshore and are typically characterized by strict banking secrecy laws in...

What is the Benefit of Being a Tax Haven?

What is the Benefit of Being a Tax Haven?

here are many benefits of being a tax haven, which is why so many people are drawn to this type of business. One of the main reasons that businesses choose to move their headquarters offshore is for the purpose of escaping high taxes and...

Is Switzerland a Tax Haven?

Is Switzerland a Tax Haven?

Switzerland is a small, landlocked country located in the Alps. It has been called a tax haven because it does not impose any taxes on personal income or capital gains - but is it really? Switzerland has one of the highest rates of taxation in...

How Can I Live Tax-Free?

How Can I Live Tax-Free?

any people are asking themselves this question. The answer is to move to a state that doesn't have any income taxes or sales tax, and then you will be able to live without having your hard-earned money go towards the government. It's not as...

Where Do the Rich Hide Their Money?

Where Do the Rich Hide Their Money?

he rich have a lot of money, so it is no surprise that they are always looking for ways to protect their assets. However, the question remains: where do they hide their cash? It can be hard to find out what people with a lot of money are doing...

Which Country Has No Tax?

Which Country Has No Tax?

axes are a big deal. In some countries, they cover up to 50% of the GDP. Some people believe that it would be better if there was no tax at all because that means each citizen's earnings will grow faster and more evenly. But which country has no...

Is Dubai a Tax Haven?

Is Dubai a Tax Haven?

he United Arab Emirates is a popular destination for ex-pats and internationals alike. The country has developed rapidly in the last 20 years, becoming one of the wealthiest countries in the world. But there are many who question whether Dubai is...

Are Tax Havens Good or Bad?

Are Tax Havens Good or Bad?

here are many arguments for and against the use of tax havens such as Switzerland, Luxembourg, or Barbados. Proponents argue that they are essential to free trade by protecting investments from taxation in other countries. Opponents claim it is a...

How Does a Tax Havens Work?

How Does a Tax Havens Work?

tax haven is a country with nominal taxes that have low or zero taxation on certain types of income. These countries typically offer favorable regulations for businesses and individuals to help them attract more capital. Tax havens can be used as...

Which Country is the Best Tax Haven?

Which Country is the Best Tax Haven?

he tax havens are a legal way of hiding money from the IRS. They allow people to put their wealth in offshore accounts, which don't have to be reported on any taxes until they're withdrawn. The United States government has been trying for years to...

Are Tax Havens Legal?

Are Tax Havens Legal?

ax havens are a controversial topic. Some people believe that tax havens are illegal, while others think they can be legal. In this article, we will explore the legality of tax havens to help you make an educated decision about whether or not it...

Best Books on Tax Havens

Best Books on Tax Havens

he best books on Tax Havens is a list of some of the most popular and reputable books that can help you learn about how to reduce your taxes by taking advantage of countries with low or no taxation policies. Whether you want to find out about the...