The total debt ratio is a measure of total debt compared to total assets. It can be used in many different areas, including the measurement of personal financial debt and the debt of a company. Although the total debt-to-income ratio can be informative, it does not always provide a definitive forecast of the prospects of a business or personal financial situation.
To determine a total debt ratio, total debt must be added and divided by gross income over a given period of time. If a person has $40,000 (USD) in debt and currently earns $20,000 per year, their total debt ratio would be 2:1, which is sometimes explained as having two dollars in debt for every dollar in assets. A business with $50,000 in debt and $200,000 in income last year would have a total debt ratio of 1:25, or $25 in assets for every dollar of debt.
It is sometimes too easy to say that a person or company with more assets than debts is in good financial shape, while a person or company with more debts than assets is in poor shape. Many debts, such as student loans or mortgages, are long-term debts that are expected to be repaid over many years or even decades. A high ratio of total debt to assets only becomes a problem if the debtor does not earn enough income to pay the debt according to an agreed schedule. A person with $100,000 in annual income and $200,000 in student loan debt may appear to be in serious financial trouble, but may actually be in an excellent position to make their monthly payment, slowly decreasing the debt ratio over time.
A high total debt to asset ratio can cause problems when trying to borrow more money, as lenders need to be reasonably sure that a person can easily repay a loan. Someone with high student loan debt, for example, may have trouble getting a home loan even if he or she earns enough money to cover both the mortgage and student loan payments. Banks and lending institutions generally want to ensure that less than about 40% of a person's monthly or annual income is used to pay off debt; This means that banks may consider them too risky to lend to because of their high overall debt ratios, even if borrowers are comfortable paying 60% of their annual income on debt.
Total debt is sometimes used in investments to determine a company's risk level. A company with a high total debt ratio is theoretically bankrupt because it does not have enough assets to pay off all its debts at once. However, most companies carry significant debt, so investment risk also takes into account related issues such as profitability and market forecasting. A company with assets far in excess of debt can still fail if its product suddenly goes out of fashion, while a company with a high total debt ratio can still be highly profitable as long as it makes its payments and remains competitive in the marketplace. As with private financing, a company's total debt ratio is really just one piece of the financial puzzle and not a definitive description of the company's performance.