Debt Ratio Explained: Formula, Examples, and What’s a Good Ratio

The debt ratio is a simple financial metric to see how much of a company is funded with borrowed money versus owner/investor money. It compares what you owe (total liabilities) to what you own (total assets), helping business owners, investors, and accountants gauge financial risk and long-term stability.

In this guide, we’ll break down what the debt ratio means, how to calculate it, the main types you’ll run into, and how to read the results so you can make smarter money decisions.

What Is the Debt Ratio?

The debt ratio is a leverage metric that measures what percentage of a company’s assets are funded by liabilities. In simple terms, it shows how much of what you own was paid for with borrowed money.

When you look at a company’s balance sheet, you see two main categories: assets and liabilities. Assets are what the company owns—cash, equipment, inventory, buildings. Liabilities are what the company owes—loans, credit lines, accounts payable, mortgages.

The debt ratio tells you the relationship between these two numbers. A higher ratio means more debt financing. A lower ratio means more equity financing. Neither is automatically good or bad—it depends on the business, the industry, and the economic conditions.

Financial managers use this ratio to assess solvency—the ability to meet long-term obligations. Banks review it before approving business loans. Investors examine it to gauge financial risk before putting money into a company.

Debt Ratio Formula and Calculation

The debt to asset ratio formula is straightforward:

Debt Ratio = Total Liabilities ÷ Total Assets

Note: In some contexts, “total debt” means interest-bearing loans only. But the classic debt ratio most businesses use is total liabilities ÷ total assets, which includes things like accounts payable and accrued expenses.

You can find both numbers on the balance sheet. Total liabilities include everything the company owes—short-term debt, long-term debt, accounts payable, accrued expenses, and other obligations.

Total assets include current assets (cash, accounts receivable, inventory) and fixed assets (property, equipment, vehicles).

Here’s how to calculate debt ratio from balance sheet data:

1. Find total liabilities on the balance sheet
2. Find total assets on the balance sheet
3. Divide total liabilities by total assets
4. Convert to a percentage by multiplying by 100

Let’s say a small construction company has $500,000 in total assets and $300,000 in total liabilities.

Debt Ratio = $300,000 ÷ $500,000 = 0.6 or 60%

This means 60% of the company’s assets are financed through debt. The remaining 40% is financed through equity (owner investment and retained earnings).

Many business owners use a debt ratio calculator to speed up this process, especially when evaluating multiple scenarios or tracking changes over time.

Factors Influencing Debt Ratio

Several factors affect what debt ratio makes sense for your business.

• Industry standards: Manufacturing companies often carry higher debt ratios because they need expensive equipment. Service businesses typically have lower ratios since they don’t require as much capital investment.
• Business lifecycle: Startups often have high debt ratios as they borrow to fund growth. Mature companies usually carry less debt relative to their assets.
• Economic conditions: During low interest rate periods, companies might take on more debt because borrowing is cheap. When rates rise, businesses often reduce leverage.
• Growth strategy: Companies pursuing aggressive expansion may accept higher debt ratios to fund acquisitions or new locations.

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Debt Ratio Variations

The debt ratio can fluctuate based on business decisions and market conditions. Purchasing new equipment increases both assets and liabilities, potentially changing the ratio. Paying down debt reduces liabilities and improves the ratio.

Seasonal businesses might see their debt ratio change throughout the year. A landscaping company might borrow in spring to purchase equipment and hire staff, then pay down that debt through summer and fall revenue.

Some analysts also track the long term debt ratio, which uses only long-term liabilities in the numerator. The long term debt ratio formula is: Long-Term Debt ÷ Total Assets. This focuses specifically on debt obligations due beyond one year.

Optimizing Debt Levels

Finding the right balance requires understanding your industry, growth plans, and risk tolerance. Too little debt might mean missing growth opportunities. Too much debt creates financial strain and limits flexibility.

Most businesses aim for a debt ratio that allows them to invest in growth while maintaining enough financial cushion to weather downturns. This sweet spot varies by industry, but staying below 0.6 (60%) gives most companies room to maneuver.

When calculating your net financial position, remember that a balanced debt ratio allows you to leverage borrowed capital for growth while maintaining enough equity cushion to weather downturns.

5 Common Types Of Debt Ratio

Different debt ratios measure leverage from various angles. Each provides unique insights into financial health.

1. Debt-to-assets ratio

The debt to total assets ratio is what most people mean when they say “debt ratio.” It’s the standard calculation we covered earlier: total liabilities divided by total assets.

This ratio shows the proportion of assets financed by debt versus equity. A debt asset ratio of 0.5 indicates that half of all assets are debt-financed.

Importance of debt to assets ratio

The debt to asset ratio explanation is simple—it shows your overall leverage at a glance. Lenders examine this ratio to determine if you can handle additional debt. A lower ratio suggests you have more equity cushion to protect creditors if things go wrong.

This metric appears in credit rating assessments. Companies with lower debt-to-asset ratios often receive better credit terms and lower interest rates.

2. Debt-to-equity ratio

The debt equity ratio compares total liabilities to shareholder equity. The formula is:

Debt-to-Equity Ratio = Total Liabilities ÷ Shareholder Equity

If a business has $400,000 in liabilities and $600,000 in equity, the debt-to-equity ratio is 0.67.

Importance of debt to equity ratio

This ratio matters because it shows how much owners have invested compared to creditors. A ratio above 1 means creditors have invested more in the business than owners—a potential red flag for lenders.

Investors use this ratio to assess financial risk. Higher debt-to-equity ratios suggest higher financial leverage, which amplifies both gains and losses.

3. Debt-to-capital ratio

The debt to capital ratio compares total debt to total capital (debt plus equity). The formula is:

Debt-to-Capital Ratio = Total Debt ÷ (Total Debt + Shareholder Equity)

This calculation focuses specifically on interest-bearing debt rather than all liabilities. It excludes accounts payable and other non-debt liabilities.

Importance of debt to capital ratio

Financial analysts prefer this ratio when evaluating companies with significant non-debt liabilities. It provides a clearer picture of actual borrowing versus total financing structure.

Companies use this metric when making capital structure decisions—whether to fund expansion through debt or equity.

4. Debt-to-EBITDA ratio

The debt to EBITDA ratio measures debt against earnings before interest, taxes, depreciation, and amortization. The formula is:

Debt-to-EBITDA Ratio = Total Debt ÷ EBITDA

This ratio shows how many years of current earnings would be needed to pay off all debt. A ratio of 3 means it would take three years of earnings to eliminate all debt.

Importance of debt to EBITDA ratio

Lenders love this ratio because it measures debt against cash-generating ability. Unlike asset-based ratios, it focuses on the company’s capacity to service debt through operations.

The debt service coverage ratio works similarly but looks at annual debt payments rather than total debt.

5. Debt-to-income ratio (Commonly used for Personal Finance)

The debt to income ratio is primarily used for personal finance rather than business analysis. According to the Consumer Financial Protection Bureau, this ratio compares monthly debt payments to monthly gross income.

Debt-to-Income Ratio = Monthly Debt Payments ÷ Monthly Gross Income

Mortgage lenders typically want to see debt-to-income ratios below 43% for loan approval.

Importance of debt to income ratio

For individuals and sole proprietors, this personal debt ratio helps determine borrowing capacity. It shows whether monthly income can comfortably cover debt obligations.

Banks use this metric when evaluating personal loans, mortgages, and credit applications. A lower income ratio means better chances of loan approval and favorable terms.

Beyond these five common types, you may also encounter variations like the debt burden ratio (which measures debt payment obligations relative to income), the debt to current assets ratio (comparing total debt to liquid assets only), and the asset to debt ratio formula (the inverse of the standard debt-to-assets calculation). Each serves a specific analytical purpose depending on what aspect of leverage you’re evaluating.

Advantages and Disadvantages of the Debt Ratio

The debt ratio is a useful starting point for understanding how a business is financed, but it doesn’t tell the whole story on its own. Like any financial metric, it has clear strengths—and important limitations. The table below breaks down the main pros and cons so you can see where the debt ratio is most helpful and where it falls short.

Using the Debt Ratio in Financial Analysis

Financial professionals rarely use the debt ratio alone. It’s most valuable when combined with other metrics.

Compare your debt ratio to the liquidity ratio to understand both leverage and ability to meet short-term obligations. A high debt ratio with strong liquidity might be manageable. A high debt ratio with weak liquidity signals trouble.

Financial analysts also examine the current ratio and interest coverage ratio alongside debt metrics to get a complete picture of financial health and debt-servicing ability.

Review debt ratios alongside profit and loss statements. Strong profitability can support higher leverage. Weak earnings make high debt ratios dangerous.

Track how your ratio changes after major decisions. Did purchasing new equipment improve efficiency enough to justify the increased debt? Are debt payments eating into profits?

Use business reports to monitor these metrics regularly. Monthly reviews help you spot problems before they become serious.

Examples of the Debt Ratio

To see how the debt ratio works in real life, let’s look at three common business scenarios and what your numbers might look like.

Example 1: You run a marketing or service-based business

• Total assets: $200,000
• Total liabilities: $50,000
• Debt ratio: $50,000 ÷ $200,000 = 0.25 (25%)

A debt ratio this low is common for service businesses that don’t need expensive equipment or large inventories. You’re using very little debt and funding most of your growth through retained earnings or owner investment. This gives you strong financial flexibility and low risk.

Example 2: You own a manufacturing business

• Total assets: $2,000,000
• Total liabilities: $1,400,000
• Debt ratio: $1,400,000 ÷ $2,000,000 = 0.70 (70%)

In this case, your debt ratio is higher because manufacturing requires significant upfront investment in machinery, equipment, and facilities. Borrowing to finance growth is normal in capital-intensive industries, and lenders often expect to see higher leverage as long as cash flow can support debt payments.

Example 3: You operate a restaurant

• Total assets: $800,000
• Total liabilities: $600,000
• Debt ratio: $600,000 ÷ $800,000 = 0.75 (75%)

Restaurants often carry higher debt due to startup costs, equipment purchases, leasehold improvements, and working capital needs. A debt ratio at this level limits financial flexibility, but it’s common in the industry—especially if your revenue is steady and you’re able to manage debt service comfortably.

What Are Some Common Debt Ratios?

Industry benchmarks help you evaluate whether your debt ratio is reasonable. These ranges are general starting points—always compare your debt ratio to similar companies in your industry.

• Service businesses: Typically 0.2 to 0.5 (20% to 50%)
• Retail companies: Often 0.4 to 0.6 (40% to 60%)
• Manufacturing: Commonly 0.5 to 0.7 (50% to 70%)
• Real estate: Can reach 0.7 to 0.9 (70% to 90%)
• Technology startups: Widely variable, often 0.3 to 0.8 (30% to 80%)

These ranges are general guidelines, and the “right” number depends on revenue stability, asset types, and how lenders view your industry.

What Is a Good Debt Ratio?

There’s no single “perfect” debt ratio. What’s considered good depends on your industry, business stage, and how stable your cash flow is. That said, the ranges below provide a helpful framework for interpreting where your business stands.

When evaluating what a “good” debt ratio is for your business, look beyond the number itself. Industry benchmarks, growth goals, revenue stability, and your ability to cover interest payments all matter. A fast-growing startup may tolerate higher leverage for a period, while a mature business usually aims for a lower, more conservative ratio.

Can a Debt Ratio Be Negative?

A negative debt ratio is technically impossible in the traditional calculation. Since assets and liabilities are both positive numbers on the balance sheet, dividing them produces a positive result.

You generally can’t have a negative debt ratio using the standard formula (total liabilities ÷ total assets). What can happen is negative equity (when liabilities exceed assets). In that case, your debt-to-equity ratio may look negative or confusing, while your debt ratio will usually be over 1.0—a serious warning sign.

A debt ratio over 1.0 means total liabilities exceed total assets—the company owes more than it owns. This is a serious warning sign indicating potential insolvency. According to IRS recordkeeping guidelines, keeping accurate financial records helps businesses identify potential solvency issues early.

Conclusion

The debt ratio is a powerful tool for understanding financial leverage and risk. By comparing total liabilities to total assets, you gain immediate insight into how your business is financed and how much financial flexibility you maintain.

Remember that no single ratio tells the complete story. Use the debt ratio alongside other financial metrics like liquidity ratios, profitability measures, and cash flow analysis. Compare your results to industry benchmarks and track changes over time to spot trends.

Whether you’re managing a business, seeking investment, or applying for loans, understanding debt ratios helps you make smarter financial decisions. Aim for a level of leverage that supports growth without creating unnecessary risk.

Get Started with Invoice Fly’s Software

Invoice Fly is a smart, fast, and easy-to-use invoicing software designed for freelancers, contractors, and small business owners. Create and send invoices, track payments, and manage your business — all in one place.

Get Started Now