What is the debt to asset ratio?
A leverage ratio that helps in quantifying the degree to which various debts fund a company’s operations is the debt to assets ratio.
In several cases, a high leverage ratio also indicates a higher degree of financial risk. It is because a heavily leveraged company usually faces a higher chance of defaulting on its loans. It is even legally obligated that the periodic debt payments are regardless of its sales numbers.
During these slow sales cycles or difficult economic times, a highly levered company may experience a loss of solvency as cash reserves have dwindled.
The debt to assets ratio can be thought of as the number of a company’s assets that have been financed by debt.
It can also provide insights on past decisions made by management regarding the sources of capital they have selected to pursue certain projects.
By extending, we can also consider the debt to assets ratio as an indirect way of measuring management’s usage of its capital structure to fund NPV-positive projects.
How to calculate debt to asset ratio?
For calculating the debt to asset ratio, you must first analyze the financial balance sheet of your business. It can also be very helpful for calculating the debt to asset ratio over time. The business has been operating, which would be giving a full picture of the financial growth or decay of the company.
The following steps will show that how to apply the debt to asset formula to calculate the ratio:
- Calculate the total liabilities.
2. Calculation of the total assets.
3. They are placing both the amounts in appropriate spots in the formula.
Calculation of the debt to asset ratio using the formula.
Debt to Assets Ratio = Total Debts / Total Assets
1. Calculation of the total liabilities
The first step in calculating your debt to asset ratio is calculating all the business’s current liabilities. You may have short-term loans, longer-term debts or other liabilities which are incurred over time. Once you get this amount, it can fit into the formula. For instance, if a company calculates all small business loans, it has received and paid back any findings received from the business’s creditors throughout its operation.
2. Calculation of the total assets
After calculating all current liabilities, you will calculate the total amount the business is having in assets. These assets can include quick assets such as cash and cash equivalents, long-term investments and any other investments that might be generating revenue for your business. Once you have this amount, please place it in the appropriate debt to asset ratio formula.
3. They are placing both the amounts in appropriate spots in the formula-
Once both amounts have been calculated, place each element into the debt to asset ratio formula. The total liabilities will be the dividend, while the total amount in assets acts as the divisor.
4. Calculation of the debt to asset ratio using the formula-
Now that your amounts are placed in their appropriate formula, you can go ahead and calculate your debt to asset ratio. Division of the total liabilities by the total assets will result in appearing as a decimal. It can also convert it into a percentage, which tells the per cent of liabilities financed by creditors, investors or other such entities.
Interpreting debt to asset ratio
Once the calculation of the debt to asset ratio is done, then you can analyze the results. Typically, a debt to asset ratio greater than one, such as 1.2, can indicate that its liabilities are higher than its assets.
Additionally, a debt to asset ratio greater than one can also show that its assets fund a large portion of the business’ debt. Higher ratios can usually indicate that the business may be at risk of defaulting on loans, especially if there is an increase in the interest rate.
Debt to asset ratio that is lesser than one, like 0.64, can indicate that might be a considerable portion of your business’ assets is funded by equity, which creates the risk for default or even low bankruptcy.
It can further convert the decimal 0.64 to a percentage, which indicates that your assets cover 64% of your business liabilities.
Comparative ratio analysis
To find relevant meaning in the ratio, it will compare with other years of ratio data for your firm by using trend analysis or time-series analysis.
Trend analysis is looking at the firm’s balance sheet data several times and determining if the debt to asset ratio is increasing, decreasing, or staying the same. The business owner or financial manager can also gain a lot of insight into the firm’s financial leverage by analysing the trend.
The analysis of the second comparative data you should perform is the analysis of the industry. To perform industry analysis, you have to look at the debt to asset ratio for other firms in your industry. You have to determine why if the debt to asset ratio is not similar.
Why the debt to asset ratio is Important for Business?
Companies having high debt to asset ratios may be at risk, especially if there is an increase in interest rates.
Creditors usually prefer low debt to asset ratios because the lower the ratio is, the more equity financing will be there, which will serve as a cushion against creditors’ losses if the firm has to go bankrupt.
Creditors will get concerned if the company carries a big percentage of the debt. They may be even calling some of the debt which the company owes to them.
Investors in the firm do not necessarily agree with these conclusions. So, if the firm raises money through debt financing, the investors who hold the firm’s stock may maintain control without having increasing their investment.
Return on Investors’ are magnified when the firm earns more on the investments it makes with borrowed money than it pays in interest. However, the investor’s risks are also magnified.
Limitations of debt to asset ratio
There are various limitations while using the debt to assets ratio. Mainly business owner or financial manager has to make sure that they have to compare apples to apples.
In different words, if they are doing industry average, then they have to be sure that the other firms in the industry to which they are comparing their debt to asset ratios while using similar terms in the numerator and denominator of the following equation.
E.g., in the numerator of the equation, all of the companies in the industry must be using either total debt or long-term debt. You cannot have few firms using total debt and even other firms using just long-term debt, or there will risk of your data getting corrupted, and you will get no valuable data.
Another issue is the usage of different accounting practices by different businesses inside the industry.
If some firms use one inventory accounting method or one depreciation method and other firms use another method, then any of the comparisons will not be valid. The Business managers and financial managers have to use a good judgment and look beyond the numbers to get an accurate debt-to-asset ratio analysis.
Various uses of debt to asset, cautions and pitfalls
As discussed previously, one of the major issues with analyzing the debt-to-assets ratio isolated from other metrics and appropriate benchmarks is that it leads to various conclusions that may not be completely accurate.
Operating with a higher degree of leverage may lead towards what it takes to make a profit for a certain business.
While this structure might not be appropriate for other businesses, then it may be for that one. Therefore, it is essential to analyze a company’s financial health that the Dearness Allowance ratio is analyzed and benchmarks of the industry.
Then it is said that if any debt-to-assets ratio is higher than 50%, then it should call for an explanation as a company that finances more than 50% of its assets with debt should outline the various reasons why it has been decided to operate under such a risky position and how it is planned to cover for both principal and various interest payments.
In some of the cases, the debt-to-assets ratio may also go down for a certain period, as big projects are being developed, yet it may normalize the situation; we must not underestimate the degree of risk that debt carries, and the management team should be in a position that it can clarify its strategy for dealing with a heavy burden of debt if it exists.
What is total debt to total asset ratio?
The total debt to total assets ratio is a leverage ratio that helps define the total amount of debt relative to those owned by a company.
Using this metric, analysts get help comparing one company’s leverage with other companies in a similar industry. This information can also reflect that how financially stable a company is.
As the ratio is higher, the higher the degree of leverage will also be higher and, consequently, the risk of investing in that company is also higher.
Understanding the total debt to total asset ratio
The total-debt-to-total-assets ratio is used for analysing a company’s balance sheet by including long-term and short-term debt such as borrowings that are maturing within one year, as well as all assets like both tangible and intangible such as goodwill.
It also indicates how much debt is used to carry a firm’s assets and how it might use those assets to serve the debt. It, therefore, also measures a firm’s degree of leverage.
It must make debt servicing payments under all circumstances; otherwise, the company would breach its debt covenants and risk being forced into bankruptcy by creditors.
While it can negotiate other liabilities such as accounts payable and long-term leases to some extent and there is very little room with various debt covenants.
Thus, a company with a higher degree of leverage may find it more difficult to stay afloat during a recession than having one with low leverage.
We should note that the total debt measure does not include several short-term liabilities like credit sales in accounts payable and long-term liabilities like capital leases and other obligations of pension plans.
What does the total debt to total asset ratio tells?
The total debt to total assets ratio measures the company’s assets financed by debt rather than equity. When it is calculated over several years, this leverage ratio will show how a company has grown and acquired its assets in a function of time.
Investors use this ratio for evaluating whether the company has enough funds to meet its current debt obligations and assess whether it can pay any return on your investment. A Creditors use the ratio to mainly to see how much debt the company already has and whether it can repay its existing debt. It will determine whether it will extend an additional loan to the firm.
A ratio that is greater than 1 shows a considerable portion of the assets which is funded by debt. In other words, the company might have more liabilities than assets. A high ratio can also indicate that a company may be putting itself at risk of defaulting on its loans if interest rates rise suddenly.
This ratio is normally below 1, meanwhile, indicates that a greater portion of a company’s assets is funded by equity.
Limitations of total debt to total asset ratio
The total-debt-to-total-assets ratio does not indicate the quality of the assets since it lumps all the tangible and intangible assets together.
E.g., assume from the example above that a company took on $50.8 billion of long-term debt for acquiring a competitor and booked $20 billion as a goodwill intangible asset for this acquisition.
If this acquisition does not perform as expected, they will be writing off the results in the entire goodwill asset. The total debt ratio to total assets (which would now be $95.8 billion – $20 billion = $75.8 billion) would be 0.67.
As with all other ratios, it should be the trend of the total-debt-to-total-assets ratio over time. It will mainly help assess whether any company’s financial type of risk profile is improving or it is deteriorating.
For example, an increasing trend will indicates that a business is mainly unwilling or unable to pay down its debt, indicating a default in the future.
Key takeover about the topic
The debt-to-asset ratio is a measurement of a business firm’s financial leverage or even solvency.
The debt-to-asset ratio is used to determine the percentage of debt the business firm uses in finance operations.
The debt-to-asset ratio is not very useful unless you have comparative data, such as you have got through trends or industry analysis.
The debt-to-asset ratio is very important for the business creditors, so they will know how much cushion they might be having against risk.
Business owners and managers should use good judgment in analyzing the debt-to-assets ratio, not just strictly the numbers.
Frequently Asked Questions:
What is debt to asset ratio?
– It is also known as the debt asset ratio; it also shows the percentage of your company’s assets that the creditor’s finance. Bankers often use the debt-to-asset ratio to see that how your assets are financed.
How to calculate debt to asset ratio?
– Now the amounts are placed in their appropriate formula; you can calculate your debt to asset ratio. As the total liabilities are divided by the total assets, you can get results that will appear decimal.
It can also convert it to a percentage, which tells the per cent of liabilities financed by creditors, investors or other such entities.
What is good debt to an asset ratio?
– Many investors are looking for a company that has a debt ratio between 0.3 and 0.6. From a pure risk perspective, ratios of 0.4 or lower are considered better, while a debt ratio of 0.6 or higher will make it more difficult for the company to borrow money.
My Name is Nadeem Shaikh the founder of nadeemacademy.com. I am a Qualified Chartered Accountant, B. com and M.Com. having professional and specialize experience in field of Account, Finance, and Taxation. Total experience of 20 years in providing businesses solution in Taxation, Accounting, and Finance with all statutory compliance with timely business performance Financials reports. You can contact me on [email protected] or [email protected]