Accounting 111: Lesson 2

                Sometimes its not enough to simply say that a company is in good health or a company is in bad health. To better understand where that company’s position is, we need to attach numbers to that health in order to compare and contrast similar companies in the market. That is where financial ratios come in to play.

In the simple terms laid out by Horngren’s Accounting, “debt ratio shows the proportion of assets financed with debt” (p. 89). This is calculated by dividing the total liabilities with the total assets. Taking the assets of a company and subtracting the equity of the company find the total liability number (Noble, 2014). For example, if a company has a total of 5400 in total assets, and a total number of 2300 in equity, the total liabilities would be 3100. To calculate the debt ratio of the company, you would divide 3100 by 5400 and come to the total of .57. This would indicate that the debt ratio of this company was 57%.  A company is seen as safer when the debt ratio is lower. The higher the debt ratio, the more risk attached to the company. Another way to look at this is the closer the debt ratio number gets to 1 (remember our debt ratio number was .57), more and more of the companies assets are being financed with debt. Generally speaking, the more debt incurred, the closer the company is to bankruptcy.

This does not mean the closer the debt ratio number gets to 1, or 100%, the less healthy that company is. When a company owns a lot of physical assets, they are most likely going to use financing to obtain those assets, and use the assets as collateral ( Loth ).

Consider the following example: a couple decides to start a rental home company. In their business plan they outline that they would like to purchase 6 houses to rent out, however they do not have the total amount of cash required to purchase these houses. They decide they will buy 5 of the 6 houses using debt. Because they are using debt to purchase physical assets, and are able to use the houses as collateral against those debts, having a higher debt ratio number would not necessarily mean that this company was not successful.

Now compare that to a company that deals mainly in services, and do not deal a lot with physical assets. For example a tech company would need some equipment and office space, but they do not need trucks to deliver a product/service. This would mean that a lower debt ratio should be incurred. The higher the debt ratio is for a company with little or no physical assets that can be used as collateral, the less healthy that company would be viewed ( Loth ).

Keep in mind that within different industries, the “acceptable” debt ratios vary. Its important to compare companies with other companies within that same industry. It wouldn’t make sense to compare a rental home company with a tech company, as the viability of the company can vary along with that debt ratio that is attached to it.

...