To understand in depth what the debt ratio is, let’s start by defining what we mean by ratio. This concept is nothing more than the ratio, proportion or coefficient between two interrelated quantities.
In economics there are several types of these reasons, which are known as financial ratios, which are divisions of certain values whose results help the economic analysis of a given company.
Financial ratios are really important, as the result of these simple divisions yield strong values that serve to project the success or failure of a company, and accordingly make the relevant decisions.
The values selected to calculate a financial ratio will depend on the type of analysis that specialists wish to perform, however these are based mainly on the balance sheets or economic statements of the companies.
A very relevant ratio, and that in this case is our central issue, is the debt ratio. If you have never heard of him or have doubts about it, then we show you everything you need to know and understand about this reason.
What is the debt ratio?
In simple words, a debt ratio is nothing more than the financial ratio that projects the financial risk that a company has against its debts. That is, the debt ratios serve to calculate the magnitude of indebtedness that a company has versus the magnitude of the assets it owns.
When applying this debt ratio, it is intended to know if the company’s debts are greater or less than the assets that make it up as such. Another way to understand the debt ratio is to see it as the point of comparison of the debts that the company has with its net worth.
How to calculate the debt ratio?
The formula for the debt ratio is very simple, and is nothing more than the division between the liabilities or debts of the company and the net worth with which this account. The results of this formula are given in decimal values.
Debt ratio = Debts / (Net worth)
According to the value that the application of the formula of the debt ratio throws, it will be determined what is the amount of money the company drinks to pay and if it exceeds or not its assets.
In other words, it seeks to know which in the amount of financing with which the company works.
Debt ratio: interpretation
Every company at some time resorts to some financing system that generates debts, either for the acquisition of new assets or to carry out a capital injection.
Thanks to the debt ratios, companies can control what capital is their own and what capital is foreign, in order to know their financial situation and if they have enough money to face their projects and, at the same time, cope to debt.
As we said before, the results of applying the debt ratio formula are given in decimal values, however they can be multiplied by 100 to obtain values based on percentages.
If after applying the formula a result of 50% is obtained, this means that of 100% of the capital of the company 50% is the result of third party financing.
Optimal or acceptable debt ratio
Determining the acceptable debt ratio is very simple; You just have to rely on the result. The optimal or acceptable value of the debt ratio ranges between 0.4 and 0.6, which are interpreted as follows:
- A value below 0.4 represents that the company is not using or properly exploiting its own resources.
- After 0.6 it is an alert signal, which means that the company is borrowing more than it owes with respect to its net capital.
We hope this information will be of great help and help you to easily understand one of the most important financial ratios.