The more debt a firm is carrying, the more difficult it may become for it to remain solvent. Basically, when a firm is unable to pay their debts, they will probably need to declare some form of bankruptcy. One way of measuring how strong a company will perform in the future, is by calculating its debt ratio. This is a tool used to help some analysts in determining whether to invest in a company or not.
The calculation is a pretty simple. Grab a balance sheet and find the Total Liabilities and Total Assets. Now divide.
This ratio should tell you whether the firm has the ability to pay its debts, and how many times over.
You can use this ratio to compare a company to its peers in the same industry as well. A company may appear to have a lot of debt in some cases. However, if you compare the company to others in the same industry, you may find that it is the industry norm to carry a little extra debt. However, if the whole industry has a ton of unsupported debt (I'm talking about you sub-primers!) than investors may want to avoid the industry.
If my readers have additional uses for the debt ratio, drop me a comment.
Thanks for reading.
-------Trevor Stasik.
Debt Ratio, Sub-Primer, Financial Tool, Analyst
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