Debt ratio is a solvency ratio that calculates a firm’s total liabilities as a percentage of its total assets. In other words, the debt ratio gives a picture as to how capable a company is to pay off its liabilities with its assets. Simply put, this shows how many assets need to be sold in order to pay off all of the liabilities.

Basically, this ratio is used to calculate the financial leverage of a company. Companies with higher levels of liabilities as compared to its assets are can be termed as highly leveraged and more risky for lenders.

This acts as an assistant to investors and creditors to anaylse the overall debt load on the firm as well as the firm’s ability to pay off the debt in future, uncertain economic times.

Formula of Debt Ratio

The calculation of debt ratio is done by dividing total liabilities by total assets. These numbers are easily accessible on the balance sheet. Here’s how to calculate the debt ratio:

Debt Ratio = Total Liabilities/Total Assets

Example

Lucky is a shop owner dealing in sports goods. He is planning to add a small warehouse on the back of the existing building for more storage. Lucky consults with his banker about applying for a new loan. The bank asks for Lucky’s balance to analyse his overall debt levels.

The balance sheet shows that Lucky has total assets of $100,000 and total liabilities of $25,000. So Lucky’s debt ratio would be calculated as:

Debt Ratio = Total Liabilites / Total Assets

Putting in the values,

Debt Ratio = $25000 / $100000

This gives us the debt ratio .25

Lucky only has a debt ratio of .25. Simply put, Dave has 4 times as many assets as his liabilities. This is a relatively low ratio and indicates that Lucky will easily be able to pay off his loan. Lucky should easily be approved for his loan.