What is a Debt Ratio?

When the time comes to ask your banker for a loan, it is very likely that your financial structure ratios will be checked: the debt ratio and the debt/equity ratio. Find out how to calculate and interpret your debt ratios.

Rate of endettement
The debt ratio is calculated by identifying your total debt and dividing it by your assets. Many websites and apps will offer a calculator service to measure your debt ratio as a tool to help you know if you’re in good financial shape to take out a loan and therefore take on more debt .

Rather than providing you with such a calculator that asks you to know your balance sheet , we will focus on understanding the concept of the debt ratio which is very simple and which boils down to this formula:

Liabilities ÷ Assets = Debt Ratio

What is the debt ratio ?
With the debt ratio , we want to know how much debt your assets have. The reason is really simple. In the event of a situation of financial insolvency, consumer proposal or personal bankruptcy , your creditors want to estimate whether they will be able to recover payment of your debts to them and in what proportion.

A concrete example of a debt ratio
Here is an example of a debt ratio to make it more concrete. If you have 1 million in assets and $500,000 in debt, we would say that you have a debt ratio of 0.5 or 50%.

What is a bad debt ratio?
Let’s say we have a debt ratio of 1.5, which means that you have a debt equivalent to one and a half times your assets. It’s starting to create a lot of debt. At this ratio, in many cases, financial services companies will be more hesitant to give you a loan and therefore increase your debts .

Debt to equity ratio
With the debt-equity ratio, we want to determine how much debt you have raised, for each dollar that you own as a shareholder in the organization. Equity dollars are the profits accumulated and left in the company and the money you have invested.

Debt ÷ Equity = Debt to Equity Ratio

What is a bad debt to equity ratio?
Generally, a banker does not want to see a ratio higher than 4. In other words, you should not exceed 4 dollars of debt for 1 dollar of equity that you put in the company.

It may seem like a lot. Indeed, but it will depend mainly on the quality of the asset that you give as collateral.

For example, for the purchase of a building for $2,000,000. When you approach a bank to borrow, the bank will offer you a maximum of 75% of your assets, so $1,500,000. You are going to have to find $500,000 of capital on your own.

$1,500,000 out of $500,000 dollars invested represents $3 in debt for every dollar invested in the company.

If your debt ratio or your debt-equity ratio is too high, the possibility of borrowing may decrease and insurance costs may increase.

In conclusion, your debt ratio as a consumer and your debt to equity ratio are going to have an influence on your borrowing capacity which it could be necessary for a possible expansion of your business. To be aware of them and to control them or to consider other avenues of expansion such as seeking grants or alternative financing must therefore be part of your reality as an entrepreneur.

Eleanore Frinqois

Eleanore Frinqois, Lead Editor at BusinessGrowthCoaching.co.uk is a business leader with over 30 years in both start-up and enterprise level organisations. Previously Operations Directer at a £1.8BN media group, alongside setting-up and later selling 3 digital brands - Eleanore has expertise across all aspects of business growth.

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