Day 6 of Fundamental Investing
The third and final solvency ratio is the Debt Ratio.
What is it?
The debt ratio is a solvency ratio that measures a firm’s total liabilities as a percentage of its total assets. In a sense, the debt ratio shows a company’s ability to pay off its liabilities with its assets. In other words, this shows how many assets the company must sell in order to pay off all of its liabilities.
This ratio measures the financial leverage of a company. Companies with higher levels of liabilities compared with assets are considered highly leveraged and riskier for lenders.
How to calculate it?
Here's an image for the same:
What's its significance?
The debt ratio is shown in decimal format because it calculates total liabilities as a percentage of total assets. As with many solvency ratios, a lower ratio is more favourable than a higher ratio. A lower debt ratio usually implies a more stable business with the potential of longevity because a company with a lower ratio also has lower overall debt.
Each industry has its own benchmarks for debt, but .5 is a reasonable ratio. A debt ratio of .5 is often considered to be less risky. This means that the company has twice as many assets as liabilities.
Or said a different way, this company’s liabilities are only 50 per cent of its total assets. Essentially, only its creditors own half of the company’s assets and the shareholders own the remainder of the assets. A ratio of 1 means that total liabilities equals total assets. In other words, the company would have to sell off all of its assets in order to pay off its liabilities. Obviously, this is a high leverage firm.
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