Debt ratio refers to the proportion of debt a company has relative to its assets. A debt ratio greater than one indicates a company has more debt than assets, and vice versa for a debt ratio less than one (See Reference 1).
- Companies borrow money through loans from banks or other companies to increase their debt ratio. The loan and its interest cost will be paid back at a future date.
- Obtaining loans increases the amount of capital available to the company. This capital provides the company the opportunity for growth.
- Increased earnings can be realized from additional capital invested into business operations (See Reference 2). Greater production output or more efficient services will benefit company earnings.
- When increased earnings are greater than the interest cost of the capital needed to raise them, more money is available to stockholders in the form of dividends.
- An increased debt ratio will magnify both gains and losses (See Reference 2). While the potential for increased earnings and dividends exists, the potential for default risk and is heightened as well.
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