How much debt is too much for your company?
To find the answer to this question, leverage ratios will come in handy, as they offer valuable information about your company and:
- the ability to cover its interests
- the way in which the assets are financed: if it’s rather through internal resources (shareholders equity) or external resources (loans)
- the ability to meet its debt obligations
- the percentage of its assets provided through debt
In this article, we will focus on debt ratio, but if you need to find out more about interest cover ratio, debt to equity ratio (D/E), or solvency ratio, download our free ebook containing the most important information you should know about financial ratios as an entrepreneur.
The debt ratio is an indicator measuring the percentage of a company’s assets provided through debt.
This indicator will tell you how much debt you have for each 1$ stored in assets. Debt ratio is a percentage and is obtained by using the formula:
Debt ratio = (Total Debts/ Total Assets) * 100
If your debt ratio is 80%, this means that for each $1 owned, you owe 80 cents. A company with a debt ratio higher than 100% has more debts than assets, therefore a lower value is usually recommended.
However, there are a lot of companies that grow based on debts because they find an efficient way to use the money and generate even more out of daily operations.
In order to gain more data on how you use and return the money you borrow, correlate debt ratio with profitability or liquidity ratios. For example, even though you have a high debt ratio, if your ROA is also increasing, then it means that you are using money efficiently and generate profit out of it – so you get the most out of your loan.
Also, if your debt ratio is high, but your current ratio is higher than 1, then you can survive without problems. Be careful with your cash flow though.
Find all leverage ratios, explained in an easy-to-understand language, in our last free ebook, Top financial indicators every entrepreneur should know. We put everything together there, profitability ratios, liquidity ratios, efficiency ratios, with real-life examples and recommendations. Happy reading!