Debt ratio

Definition

The debt ratio, also known as the debt-to-equity ratio, is a financial metric used to assess the proportion of a company’s total liabilities in relation to its total equity.

What is a debt ratio?

A debt ratio provides insights into the extent to which a company is financed by debt versus equity. 

Calculation of debt ratio:

Debt ratio = total liabilities /  total equity​

A higher debt ratio indicates that a larger portion of a company’s assets are financed by debt, while a lower debt ratio suggests that a company relies more on equity financing. Companies with higher debt ratios may be considered riskier to investors and creditors. 

There is no one-size-fits-all ideal debt ratio, as it depends on various factors including the industry, business model, and risk tolerance. What may be considered an acceptable debt ratio for one industry might be considered high for another.

The debt ratio, along with other financial ratios, is typically disclosed in a company’s financial statements. This provides transparency to stakeholders about the company’s capital structure and financial risk.

Example of debt ratio

Let’s consider an example for a fictional company, ABC Ltd.:

Total Debt:

• ABC Ltd. has long-term debt (e.g., bonds and loans) amounting to ₦500,000.
• Short-term debt (e.g., short-term loans) totals ₦50,000.

Total debt = ₦500,000 + ₦50,000 = ₦550,000

Total assets:

• ABC Ltd.’s total assets amount to ₦1,200,000.

Now, using the formula for the debt ratio:​

Debt ratio = ₦550,000 / ₦1,200,000 $\approx 0.4583$

In this example, ABC Ltd. has a debt ratio of approximately 45.83%. This means that 45.83% of the company’s total assets are financed by debt.