We are in the middle of reviewing 5 financial measurements covered in our FREE Business Health Check that can provide your business with an understanding of what it can be working on to help it do more. In our experience, most SME businesses do not know what these 5 financial ratios mean and how they relate to their business planning. We have covered the Quick Ratio and the Current Ratio with this posting detailing what a Debt Ratio is and what it means.
A Debt Ratio is the comparison of total debt to total assets. In our last posting we covered the Current Ratio which compares Current Assets to Current Liabilities and the Debt Ratio is a further comparison of debt to assets. The formula for a Debt Ratio is simply:
Debt Ratio = Total Assets / Total Liabilities
When working with banks and lenders (on behalf of our clients), a Debt Ratio needs to be less than 50%. As a business owner you would want to see a Debt Ratio that is less than 50% as well because it reflects how much equity you may have in the business. Indirectly, a Debt Ratio also provides some insight into cash flow as a high Debt Ratio would mean cash from the business is being used to make principal and interest payments against the debt of the business.
By itself, a Debt Ratio does not tell the whole story of a business but certainly helps a business owner understand what a first step might be in planning for success. If a business knows it needs to be less than 50% with its Debt Ratio then beginning to understand what would need to happen in the business to produce the result could lead to great opportunities for improvement.
In the next posting we cover, Debt Service Ratio which helps us specifically identify another aspect of where cash from a business is going.