The debt ratio is a simple indicator of the leverage used by a company. The debt ratio measures the proportion of the total assets that are financed by debt, and not by stockholders.
Debt Ratio = Total Liabilities / Total Assets
The debt ratio requires only two inputs in its calculation, both of which can be obtained from a company's balance sheet. By dividing liabilities by assets, this ratio tells the analyst how much debt was used to finance the assets of the company.
A relatively high debt ratio will produce good results for stockholders as long as the company earns a rate of return on assets that is greater than the interest rate paid to creditors. As the ratio increases, there is a greater risk that creditors could force the company into bankruptcy if it falls behind on interest payments.
Generally, it's desirable to have a debt ratio that is less than 0.5. When a company's ratio rises above 0.5, it is said to be highly leveraged. When drawing conclusions about the relative performance of a company, benchmark comparisons should be made with competitors in the same industry.
Company A's balance sheet indicates total assets of $31,616,000 and total liabilities of $16,196,000. Using the above formula, the debt ratio would be:
= $16,196,000 / $31,616,000, or 0.51