If a person show you a home and tells that he is the owner of that home worth 2 Million dollars. After this statement you may ask the person “ Whether the home is 100 % self financed or you took money from bank or someone else?”. The person can either tell you that 100 % amount of home is self financed or partial amount is self financed and rest is the liability which Bank financed on the cost of Interest rate.
The purpose of the above story to help you to better understand the debt ratio concept. Debt ratio calculates the portion of total liabilities within the total assets of the company. It compares the total liabilities with the total assets of the company. Debt Ratio value can be obtained by dividing total liabilities with total assets of the company as mentioned in the below equation.
Debt Ratio = Total Liabilities of the Company
Total Assets of the Company
Debit Ratio = 10 Million
Debit Ratio = 0.5 X 100 = 50 %
it means Company XYZ assets are financed by external sources. XYZ Company has 50 % liabilities provided by external sources such as Banks on some cost known as cost of capital. Higher the percentage more will be the cost of capital company has to pay to the investors. High value debt ratio is not good for the health of the company on the other hand lower value debt ratio show the strong position of the company in term of equity.
There is one catch in debt ratio by saying that I mean if company is generating enough revenues to accommodate cost and capital and get profit as well in that case it will become beneficial instead of harming the financial condition of the company. Most of the times companies willingly go for the debt to minimize the tax amount because tax is always charged after deducting the interest rates.