The debt to asset ratio formula shows the relationship between total debt to total assets of a firm. The debt ratio gives the percentage of assets financed by debt; this financial metric helps to determine the percentage of assets that are financed by debt which in turn helps one to determine the financial leverage of a company. We will see how to apply this formula in the debt-to-asset ratio calculation; its importance as well as its interpretation.
What is a debt-to-asset ratio?
The debt to asset ratio is a financial metric that indicates the percentage of assets that are being financed with debt. It is also known as the debt ratio. A higher debt to asset ratio indicates that there is a greater degree of leverage and financial risk.
Creditors commonly make use of the debt ratio to determine the amount of debt in a company, the ability to repay its debt, and whether there will be extensions of additional loans to the company. Investors on the other hand use the ratio to ensure that the company is solvent, whether it is able to meet current and future obligations, and whether the company can generate a return on investment. With this, it is possible to note that the debt-to-asset ratio is a solvency ratio.
This financial metric is very important in determining a company’s financial risk. When a ratio is greater than 1, it indicates that a significant portion of assets is funded with debt and that the default risk of the company is higher. This, on the other hand, means that the lower the ratio, the safer the company.
In essence, a high ratio could imply that the company will have trouble borrowing more money or that it may borrow money only at a higher interest rate than if the ratio were lower. As it is with other ratios, this metric should be evaluated over a period of time to access whether the company’s financial risk is improving or deteriorating.
Companies that are highly leveraged may be putting themselves at risk of insolvency or bankruptcy depending on the type of company as well as the industry. Some industries can make use of more debt financing than others.
The debt-to-asset ratio gives financial managers a critical insight into a firm’s financial health or distress. If for example, a company’s debt to asset ratio is 0.55, it implies that some form of debt has supplied 55% of every amount in the company’s assets. If debt has financed 55% of a firm’s operations, then equity has financed the remaining 45%.
Therefore, the debt ratio represents the percentage of the total debt financing a firm makes use of as compared to the firm’s total assets. As earlier stated, it helps to determine how much of a company’s assets were financed by debt.
Debt to asset ratio formula
The debt to asset ratio formula is represented as follows;
Debt to asset ratio = Total debt / Total assets
In the debt to asset ratio formula above, the debt includes both short-term debt and long-term debt, while total assets include all fixed and current assets. In some cases, it may only include certain assets such as Property, Plant & Equipment (PP&E), at the discretion of the analyst.
Debt-to-asset ratio calculations
- Calculate the total liabilities
- Calculate the total assets
- Put both amounts at the appropriate spots in the debt-to-asset ratio formula
- Carry out the calculation using the debt-to-asset ratio formula
To calculate the debt ratio, one has to first analyze the financial balance sheet of the company. It can also be helpful to calculate this financial metric over the time that the business has been operating. This will give a full picture of the financial growth or decay of the company. The steps that show how to apply the debt to asset ratio formula to calculate the ratio are explained below:
Calculate total liabilities
The first step to take in calculating all your debt is to calculate all current liabilities incurred by the business. There may be short-term loans, long-term debts, or other liabilities incurred over time. Once this amount is gotten, it can fit into the debt to asset ratio formula. For instance, a company may calculate all the small loans it has received and is paying back as well as any funding the business has received from its creditors throughout its operation.
Calculate total assets
The next step to take after calculating all current liabilities is to calculate the total amount the business has in its assets. These assets can include quick assets such as cash and cash equivalents, long-term investments, other investments that have generated revenue for the business, and fixed assets. Once this amount has been compiled, place it in the appropriate spot of the debt to asset ratio formula.
Put both amounts at the appropriate spots in the debt to asset ratio formula
Once both amounts have been calculated or compiled from the company’s financial statements, each element is to be placed at the appropriate spot of the debt to asset ratio formula. The total liabilities will be the dividend while the total amount in the assets will act as the divisor.
Carry out the calculation using the debt to asset ratio formula
After the amounts have been placed in their appropriate spots in the formula, one can go ahead and calculate the company’s debt-to-asset ratio. The total liabilities should be divided by the total assets and the result will appear as a decimal. It can also be converted into a percentage when you multiply it by 100.
Debt to asset ratio examples
We can consider the balance sheet below:
|Property and equipment||45,000|
|Total liabilities and shareholders’ equity||226,376|
From the balance sheet above, we can determine that the total assets are $226,376 and the total liabilities are $53,902. Having looked at the balance sheet, we can now place the figures at the right spot in the debt to asset ratio formula.
Debt to asset ratio = Total debt / Total assets
Debt to asset ratio = $53,902 / $226,376
Debt to asset ratio = 0.2381 = 23.8%
From the calculation, we can say that 23.8% of the company’s assets are funded by debt.
As earlier stated, analysts, investors, and creditors commonly make use of the debt to asset ratio in order to determine the overall risk of a company. Companies that have a higher ratio are more leveraged and in turn riskier to invest in and provide loans to. If there is a steady increase in the ratio, it could indicate that there will be a default at some point in the future.
Once the debt to assets ratio calculation is carried out, then analysis can now take place.
A ratio that is equal to 1 means that the company owns the same amount of liabilities as its assets which is an indicator that the company is highly leveraged.
A ratio that is greater than 1 means that the company owns more liabilities than its assets which is an indicator that the company is extremely leveraged. In essence, such a company is highly risky to invest in or lend to.
A debt to asset ratio that is less than 1 means that the company owns more assets than liabilities. This indicates that the company can meet all its obligations by selling its assets if there is a need to do so. The lower the ratio, the less risky the company.
The debt to asset ratio is important to investors, analysts, and creditors as it helps them in determining the overall risk of a company. Because a high debt to asset ratio indicates that the company may be at risk, creditors prefer low ratios because the lower the ratio, the more equity financing there is for the company. It serves as immunity against losses on the part of the creditors in case the company goes bankrupt. It is a concern for creditors if the company carries a large percentage of the debt.
More equity financing or funds supplied by business owners than debt financing means that there is a lower risk and a margin of safety for both the firm and its creditors.
The debt ratio has limitations. The business owner or the financial manager needs to ensure that they are making comparisons with other firms in the industry that are making use of the same terms in the numerator and denominator of the debt to asset ratio formula. This means that if a company is comparing its debt to asset ratio with another company that is not using the same terms, then it will be ineffective.
For example, in the numerator of the equation, all the firms in the industry must make use of either total debt or long-term debt. It should not be that some forms are using total debt while other firms are using just long-term debt. If this happens, the data will be corrupted and the company will not get any helpful data.
Another challenge is the use of different accounting practices by different companies in the industry. If some firms make use of one inventory accounting method or one depreciation method while others make use of other methods, then any comparison made will not be valid.
With this, business managers and financial managers must make use of good judgment and look beyond the numbers to get an accurate debt to asset ratio analysis.Last Updated on November 6, 2023 by Nansel Nanzip Bongdap