Debt ratio is a frequently overlooked financial metric. When running a business, you’ll probably focus on your net revenue simply because this reveals the total amount of profits your business earns in a given period. While important, however, there are other financial metrics you should track, including debt ratio. So, what is debt ratio in accounting, and how do you calculate your business’s debt ratio?
Debt Ratio Explained
Debt ratio refers to the difference between your business’s total liabilities and its total debt. To calculate debt ratio, take your business’s total liabilities and divide it by its total assets, at which point you’ll have your business’s debt ratio.
Here’s an example of how to calculate debt ratio: Let’s say your business has $500,000 in total assets and $250,000 in total liabilities. Take $250,000 and divide it by $500,000. This equals a debt ratio of 0.5. Any debt ratio below 1 is good because it means that your business’s total assets are greater than its total liabilities. If your business’s debt ratio is higher than 1, it means the cost of your liabilities is greater than the value of your assets.
Assets vs Liabilities:
To calculate debt ratio, you’ll need to add up all your business’s assets as well as its liabilities. Assets, of course, are something of value that provides economic benefit for your business. In comparison, liabilities include debt that your business is required to pay.
Assets may include your business’s cash, equipment, vehicles, office furniture and stock shares. Liabilities may include accounts payable, salaries payable, interest payable, income taxes payable and customer deposits. For effective debt ratio tracking, you must calculate all your business’s liabilities and divide it by all your business’s assets.
The Importance of Tracking Debt Ratio
Tracking your business’s debt ratio is important for several reasons. For starters, it provides a better understanding of your business’s cash flow. A high debt ratio will restrict your business’s cash flow, which could hinder your operations and prevent your business from growing and expanding into new markets. Your business’s debt ratio can also affect its a eligibility for funding. If you are seeking a loan to fund your business, lenders may scrutinize your debt ratio to determine if you are a suitable candidate. While private lenders are always an option, many banks will reject your application for a loan if your business has a high debt ratio.
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