What is a Total Debt Ratio?
Total debt ratio is a measurement of total debts compared to total assets. It can be used in many different fields, including to measure personal financial debt and the debts of a business. While total debt ratio can be informative, it does not always give a definitive forecast of the prospects of a business or personal finance situation.
To find a total debt ratio, it is necessary to add up total debt and divide it by gross income over a given period. If a person has $40,000 US dollars (USD) in debt and currently makes $20,000 USD per year, his or her total debt ratio would be 2:1, which is sometimes explained as having two dollars of debt for every one dollar of assets. A business that has $50,000 USD in debt and an income of $200,000 USD over the past year would have a total debt ratio of 1:25, or $25 in assets for every one dollar of debt.
It is sometimes overly simplistic to say that a person or business with more assets than debts is in good financial health, while one with more debts than assets is in bad health. Many debts, such as student loans or mortgages, are long-term debts meant to be paid off over many years or even decades. A high total debt to asset ratio becomes an issue only if the debtor does not make enough income to pay off debts on an agreed schedule. A person with $100,000 USD in yearly income and $200,000 in student loan debt may appear to be in serious financial trouble, but in fact may be in an excellent position to make his or her monthly payment, thereby slowly reducing the debt ratio over time.
A high total debt to asset ratio can cause problems when trying to borrow more money, since lenders need to be reasonably sure that a person can pay a loan back without problems. Someone with high student loan debt, for instance, may have difficulty securing a home loan even if he or she makes enough money to cover both mortgage and student loan payments. Banks and lending institutions generally want to make sure that less than about 40% of a person's monthly or yearly income goes to paying off debts; this means that, even if borrowers are comfortable paying 60% of their yearly income on debt, banks may consider them too risky to loan money to because of their high total debt ratio.
Total debt is sometimes used in investing to determine the risk level of a business. A company with a high total debt ratio is theoretically in danger of bankruptcy, since they do not have enough assets on hand to pay off all debts at once. Most companies, however, do carry considerable debt, so investment risk also considers related issues such as profitability and market forecast. A business with assets far in excess of debt can still fail if their product suddenly goes out of style, whereas a business with a high total debt ratio may still be extremely profitable so long as they can make their payments and remain competitive in the market. As in personal finance, the total debt ratio of a business is really only a piece of the financial puzzle, instead of a definitive description of the company's success.
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