What it is:
A debt ratio is simply a company's total debt divided by its total assets.
How it works (Example):
The formula for the debt ratio is:
Debt Ratio = Total Debt / Total Assets
For example, if Company XYZ had $10 million of debt on its balance sheet and $15 million of assets, then Company XYZ's debt ratio is:
Debt Ratio = $10,000,000 / $15,000,000 = 0.67 or 67%
This means that for every dollar of Company XYZ assets, Company XYZ had $0.67 of debt. A ratio above 1.0 indicates that the company has more debt than assets.
Why it Matters:
The debt ratio quantifies how leveraged a company is, and a company's degree of leverage is often a measure of risk. When the debt ratio is high, the company has a lot of debt relative to its assets. It is thus carrying a bigger burden in the sense that principal and interest payments take a significant amount of the company's cash flows, and a hiccup in financial performance or a rise in interest rates could result in default.
When the debt ratio is low, principal and interest payments don't command such a large portion of the company's cash flows, and the company is not as sensitive to changes in business or interest rates from this perspective. However, a low debt ratio may also indicate that the company has an opportunity to use leverage as a means of responsibly growing the business that it is not taking advantage of.