What exactly is debt ratio?

We often hear talk of debt ratio in the financial news, and of its impact on the finances and valuation of companies. But what is it and how does it work?

The basic definition of a debt ratio is a financial ratio measuring the size of a company’s or consumer’s leverage. Leverage is the extent to which a person or business has borrowed versus their total worth. So the debt ratio compares the company or individual’s total debt to their total combined assets. Debt ratio is a percentage number that can be viewed as an indication of how much of a person's or business’ assets are being financed by debt.

The effect of debt ratio is relatively intuitive. The higher a given debt ratio is, the more leveraged the company or individual is. That means that they carry a higher level of risk for potential lenders, investors or anyone looking to buy out the company in question.

You might remember the term debt ratio from news stories during the financial crisis. The crux of the issue was that many large companies – particularly banks, holding companies and hedge funds – were allowed to accrue very high debt ratios.

Loosened financial regulations combined with new ways to package debt – often called exotic financial products – made for an environment where some of the most important financial institutions were reaching historically high degrees of leverage.

This meant that these organizations were able to invest more borrowed money and seek greater profits on a smaller amount of assets. When any individual company defaulted (failed to pay their debt obligations), it initiated a domino effect where the company they failed to pay back was then unable to make good on their own debt payments.

The result was well publicized, starting with overly leveraged, high-risk mortgages that ended up being defaulted on. Because the companies backing those mortgages had many other financial obligations, the mortgage crisis spread into other sectors not related to property itself.

It’s something of a simplification, but this scenario is instructive even for an individual’s debt ratio. If you borrow a lot of money based on your expectation of being able to service the debt in the future, and an unforeseen event prevents you from paying off your loans, it will naturally impact all of your other financial obligations, since your money and assets are liquid across all of your expenditures.