Debt ratios can be used to describe the financial health of individuals, businesses or governments. Like other accounting ratios, investors and lenders calculate the debt ratio for a business from major financial statements.
How Debt Ratios Work
The debt ratio for a given company reveals whether or not it has loans and, if so, how its credit financing compares to its assets. It is calculated by dividing total liabilities by total assets, with higher debt ratios indicating higher degrees of debt financing. Whether or not a debt ratio is good depends on the context within which it is being analyzed.
From a pure risk perspective, lower ratios (0.4 or lower) are considered better debt ratios. Since the interest on a debt must be paid regardless of business profitability, too much debt may compromise the entire operation if cash flow dries up. Companies unable to service their own debt may be forced to sell off assets or declare bankruptcy.
A higher debt ratio (0.6 or higher) makes it more difficult to borrow money. Lenders often have debt ratio limits and do not extend further credit to firms that are over-leveraged. Of course, there are other factors as well, such as credit worthiness, payment history and professional relationships.
Source : Investopedia