Debt Ratio: Interpreting, Calculating, and Optimizing Financial Health

Basically, this method anticipates that some of the debt will be uncollectable and attempts to account for this right away. 11 Financial may only transact business in those states in which it is registered, or qualifies for an exemption or exclusion from registration requirements. This understanding is crucial for investors and analysts to ascertain a company’s financing strategy. In contrast, companies looking to expand or diversify might subscription billing vs one again increase borrowing, potentially raising the ratio. Understanding where a company is in its lifecycle helps contextualize its debt ratio.

The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. It offers insights into the company’s long-term solvency and its ability to meet its long-term obligations. In order to get a more complete picture, investors also look at other metrics, such as return on turbotax premier online customer ratings and product reviews investment (ROI) and earnings per share (EPS) to determine the worthiness of an investment. Before wrapping up, let’s consider a balanced approach to debt management in our final thoughts. Yes, legal implications may exist depending on the circumstance in which the debt was incurred and/or not paid back.

Allowance method

During times of high interest rates, good debt ratios tend to be lower than during low-rate periods. Whether or not it’s a good ratio depends on contextual factors; there is no universal number. Let’s take a look at what these ratios mean, what the variations are, and how they’re used by corporations.

Conversely, technology startups might have lower capital needs and, subsequently, lower debt ratios. Comparing a company’s debt ratio with industry benchmarks is crucial to assess its relative financial health. This can include long-term obligations, such as mortgages or other loans, and short-term debt like revolving credit lines and accounts payable. In this technique, the bad debt is directly considered as an expense, and the debt ratio is calculated by dividing the uncollectible amount by the total Accounts Receivables for that year. In that case, you simply record a bad debt expense transaction in your general ledger equal to the value of the account receivable (see below for how to make a bad debt expense journal entry).

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Payments received later for bad debts that have already been written off are booked as bad debt recovery. The allowance for doubtful accounts nets against the total AR presented on the balance sheet to reflect only the amount estimated to be collectible. This allowance accumulates across accounting periods and may be adjusted based on the balance in the account. Bad debt is any credit advanced by any lender to a debtor that shows no promise of ever being collected, either partially or in full. Any lender can have bad debt on their books, whether it’s a bank or other financial institution, a supplier, or a vendor. It gives a fast overview of how much debt a firm has in comparison to all of its assets.

1. A bad debt expense is a financial transaction that you record in your books to account for any bad debts your business has given up on collecting.
2. However, companies that regularly extend credit face higher risks than others.
3. By estimating bad debts before they occur, companies can maintain an allowance for doubtful accounts in a contra asset account.
4. Bad debt expense is an accounting term that refers to the estimated amount of uncollectible debts that a business is likely to incur during a given period.

Is it possible to write off bad debts on taxes?

Often, the debt ratio is part of a larger group of financial ratios used to evaluate a company’s overall financial health. Comparing the debt ratio to other financial ratios, such as the equity ratio or liquidity ratios, gives a more comprehensive perspective. Every decision on a company’s debt ratio comes with its own set of rewards and risks. A high debt ratio might provide more resources for growth and expansion, but it also brings potential financial risk if the borrowing company struggles to repay the debt. We’ve understood the basic concept of debt ratios, but how do we interpret them?

Think about how these ratios compare to other financial ratios, and we’ll get into that in the next section. Let’s look at a few examples from different industries to contextualize the debt ratio. Bad debt is an amount owed to a business that is considered—or proves to be—irrecoverable. There are several reasons why a debtor may fail to pay an amount due, including death, bankruptcy, insanity, and others.

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A lower debt ratio often suggests that a company has a strong equity base, making it less vulnerable to economic downturns or financial stress. The debt ratio offers stakeholders a quick snapshot of a company’s financial stability. Because of this, what is considered to be an acceptable debt ratio by investors may depend on the industry of the company in which they are investing. The purpose of calculating the debt ratio of a company is to give investors an idea of the company’s financial situation. Managing bad debts is crucial for maintaining a healthy financial position and safeguarding profits.

But this isn’t always a reliable method for predicting future bad debts, especially if you haven’t been in business very long or if one big bad debt is distorting your percentage of bad debt. Offer your customers payment terms like Net 30 and Net 15—eventually you’ll run into a customer who either can’t or won’t pay you. When money your customers owe you becomes uncollectible like this, we call that bad debt (or a doubtful debt). Remember, understanding your debt ratio is a critical part of managing financial health, whether you’re running a business or considering an investment decision.

What Is the Bad Debt to Sales Ratio?

Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.

Like any other expense account, you can find your bad debt expenses in your general ledger. However, that’s not always a certainty—it’s a balance game, as we’ll explore next in the factors influencing an optimal debt ratio. If a company’s bad debt as a percentage of its sales is increasing, it can be a sign of trouble. Therefore, it can be useful to calculate and monitor the percentage of bad debt over time. Let’s say a company has $70,000 of accounts receivable less than 30 days outstanding and $30,000 of accounts receivable more than 30 days outstanding. Based on previous experience, 1% of AR less than 30 days old will not be collectible, and 4% of AR at least 30 days old will be uncollectible.

Here’s why this measurement of the profitability of your operations is important. The Ascent is a Motley Fool service that rates and reviews essential products for your everyday money matters. Pete Rathburn is a copy editor and fact-checker with expertise in economics and personal finance and over twenty years of experience in the classroom. Ask a question about your financial situation providing as much detail as possible. Our goal is to deliver the most understandable and comprehensive explanations of financial topics using simple writing complemented by helpful graphics and animation videos.

Accountants rely on several performance indicators to track progress and facilitate a proactive response to potential problems. Two companies with similar debt ratios might have significantly different interest obligations, impacting their overall financial performance and risk. Companies with high debt ratios might be viewed as having higher financial risk, potentially impacting their credit ratings or borrowing costs. Discover smart advice from one of our clients, Yaskawa America, who achieved zero bad debt by leveraging automation. Automation played a crucial role in Yaskawa’s success, providing better visibility, secure payment processing, reduced manual workload, and cost optimization.

Tune in for the next section where we discuss the risks and benefits of varying debt ratios. Financial data providers calculate it using only long-term and short-term debt (including current portions of long-term debt), excluding liabilities such as accounts payable, negative goodwill, and others. The concept of comparing total assets to total debt also relates to entities that may not be businesses. For example, the United States Department of Agriculture keeps a close eye on how the relationship between farmland assets, debt, and equity change over time.