Debt analysis can have slightly different meanings depending on context. When used to assess the financial health of an individual, it is basically a comparison of how much the person, or a household, makes versus how much he owes. Consumers usually owe money but typically are not owed much. However, businesses often are lenders as well as borrowers and can use debt analysis to asses their assets or liabilities.
Consumers
When analyzing the debt of an individual, the primarily concern is the person's repayment ability. This capability to make good on debts helps determine how much the individual can borrow and the interest rate she must pay for new loans. As a general rule, the lower the debt-to-income ratio, the better the individual's financial health and future repayment ability. The better the person's, or the household's, financial health, the easier it is to obtain new loans and lower interest rates.
Example
According to TransUnion, one of the three major credit bureaus in the United States, a debt-to-income ratio between 20 percent and 39 percent qualifies as good. If you make $1,500 per month, for instance, and your monthly debt payments are $450, your debt-to-income ratio stands at 0.3 or 30 percent. This puts you in the middle of the "good" range, as described by TransUnion. As your debt-to-income ratio rises, the probability that you will not be able to pay some of your loans also goes up. The less money you have left after paying for your debts, the less flexibility you have and the easier it is for an unforeseen expense to drive you into insolvency.
Limitations
The nature of your debt, in addition to its quantity, also plays a critical role in determining your financial health. Therefore, a simple ratio can be misleading. If you are currently paying a loan on a second car and only need one, for example, you can usually sell the car and get rid of the loan. If you bought the car used, you may not lose much money during the resale while getting rid of a sizable payment. You do not have such flexibility with credit card bills, however. Therefore, a thorough analysis must consider the nature of the loan as well as its magnitude.
Business Use
Businesses apply much the same principles when analyzing their debt burden. The amount of loan payments as a percentage of the company's income is a key determinant of its repayment ability. In addition, debt divided by total assets also provides important clues. However, businesses often are owed a large amount of money as well. The analysis of loans extended to customers can be referred to as "debt analysis." Such an investigation must consider the financial health of the borrowers, how far behind they are on payments, and the concentration of credit extended. The last metric is used to see whether most of the money is owed by a few borrowers. Such a situation is undesirable as the bankruptcy of one such big customer can result in serious trouble.
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