Financial Ratios Part II: Debt Ratios
Debt Ratios can help determine what percent of assets are offset by debt and whether or not you can meet your current and long-term debt obligations.
Debt Ratio = Total Liabilities / Total Assets
The debt ratio tells you what percentage of your assets is financed with borrowed money. For example, if the only asset you owned was your home and you purchased it for $100,000 by borrowing $95,000 and putting $5,000 down, your debt ratio would be 95% ($95,000 (total liabilities) / $100,000 (total assets)). In essence, 95% of your assets have been financed through debt. The remaining 5% would be the “equity” you own in the home. If the ratio is ever above 1, it means you have negative networth. Having a negative networth means that if you were to sell all of your assets for what they are worth, you would not have enough to cover your debt.
As you track this ratio, you should see a downward trend. The closer the ratio is to zero, the better. When the ratio hits zero, you are debt free. Many investors may argue that you don’t want this ratio at zero because that means you’re not using the power of leverage. I agree there is a time and place for debt and the use of leverage, however, I also know there is nothing that can substitute freedom from debt.
Long-term Debt Coverage Ratio = Monthly Living Expenses / Monthly Debt Payments
The long-term debt coverage ratio tells you how many times over you could pay debt obligations based your monthly living expenses. I think a more useful way of looking at this ratio is to reverse the positions of the two expenses in the equation (Monthly Debt Payments / Monthly Living Expenses). This calculation actual gives you a percentage of your current monthly expenses that are made up of long-term debt.
For example, if your total monthly expenses equal $4,500 and your monthly payments on long-term debt obligations equals $1,950, your Long-Term Debt Coverage Ratio would equal (4,500/1,950) 2.31. Perhaps better said, 43.33% (1,950/4,500) of your monthly expenses are made up of long-term debt obligations.
Referring to the original equation, the higher the ratio the better. A higher ratio indicates that you could cover debt payments for a longer period of time if you had a loss of income. As you track this ratio you should see an upward trend. If you look at the ratio by the 2nd method you’ll want to see it as low as possible.
*For an explanation of the other ratios I use, check out my other financial ratio posts (Liquidity Ratios, Debt Ratios, Saving Ratios, & Networth Ratios).
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[...] Debt Ratio: This is the first month that we actually have a debt ratio that means anything. We’ve finally put the house and mortgage on the balance sheet and now we can see that effect on the debt ratio. A .70 debt ratio basically tells us that 70% of our assets are financed with debt…aka, 70% of our total assets are made up of our home. [...]
[...] an explanation of my ratios and how they are calculated check out my Financial Ratios posts (Liquidity Ratios, Debt Ratios, Saving Ratios, & Networth Ratios). Share and [...]