Debt To Asset Ratio Meaning
The debt to asset ratio is the ratio of the total debt of a company to the company’s total assets; this ratio represents the ability of a company to have the debt and raise additional debt if necessary for the company’s operations. A company that has a total debt of $20 million out of $100 million total assets has a ratio of 0.2.
This ratio explains the portion of the capital structure of a business that has been funded by debt. It is used to calculate the risk level or leverage if the company and also shows the obligations like interest payments on bonds or loans. Thus is it the level of indebtedness of the business.
Table of contents
- The debt-to-asset ratio is a financial ratio that measures the proportion of a company’s assets that are financed with debt. It is calculated by dividing a company’s total debt by its assets.
- It is vital to know this ratio because creditors commonly use it to determine debt quantity in a company and examine the company’s capability of debt repayment ability.
- Investors, analysts, and creditors usually utilize this ratio to assess a company’s all in all risk.
- The higher ratio shows that the company is more leveraged. Therefore, it is a risky investment.
Debt To Asset Ratio Explained
An ideal debt to asset ratio explains the part of the capital structure of the company that has been financed through the loan. Therefore, it shows the interest obligations of the business in bonds and loans. It helps in evaluating the financial risk of the business because investors can use this metric to assess the loan taken by the business and accordingly make investment decisions.
It involves both short and long-term debt which are compared with the total assets. A company with a high ratio has high risk or leverage and, thus, is not considered financially very flexible. This is because it is dependent on creditors to finance its operations and may end up paying very high amount of interests on loan that will erode its profits. On the other hand, it will have less fund to meet its day to day operations, hindering its growth and expansion. However, debt may provide immediate cash flow to the business. But it should be reasonable and within limits.
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Debt to asset indicates what proportion of a company’s assets is financed with debt rather than equity. The formula is derived by dividing all short-term and long term debtsLong Term DebtsLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company's balance sheet as the non-current liability. (total debts) by the aggregate of all current assetsAll Current AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc. and noncurrent assetsNon-current AssetsNon-current assets are long-term assets bought to use in the business, and their benefits are likely to accrue for many years. These Assets reveal information about the company's investing activities and can be tangible or intangible. Examples include property, plant, equipment, land & building, bonds and stocks, patents, trademark. (total assets). A good debt to asset ratio helps in the assessment of the percentage of assets that are being funded by debt is-à-vis the percentage of assets that the investors are funding.
Mathematically, it is represented as,
Debt to Asset ratio Formula = Total debts / Total assets
How To Calculate?
The ideal debt to asset ratio calculation involves some steps as given below.
- Firstly, the company’s total debt is computed by adding all the short-term debts and long-term debts that can be gathered from the liability side of the balance sheet.
Total debts = Total short term debts + Total long term debts
- Next, the company’s total assets can be computed by adding all the current and noncurrent assets that can gather from the asset side of the balance sheet.
Total assets = Total current assets + Total non-current assets
- Finally, the debt to asset ratio formula can be derived by dividing the total debts (step 1) by the total assets (step 2).
Let’s see some simple to advanced debt to asset ratio example to understand them better.
Let us take the example of a company called ABC Ltd, which is an automotive repair shop in Brazil. The company has been sanctioned a loan to build a new facility as part of its current expansion plan. Currently, ABC Ltd has $80 million in non-current assets, $40 million in current assets, $35 million in short-term debt, $15 million in long-term debt, and $70 million in stockholders’ equity. Calculate the debt to the asset for ABC Ltd.
As per the question,
- Total debts = Short term debts + Long term debts
- = $35 million + $15 million
- = $50 million
- Total assets = Current assets + Non-current assets
- = $40 million + $80 million
- = $120 million
Therefore, the debt to asset ratio example is as follows –
- Debt to Asset = $50 million / $120 million
Ratio will be –
- Debt to Asset = 0.4167
Therefore, we can say that 41.67% of the total assets of ABC Ltd are being funded by debt.
Let us take the example of Apple Inc. and calculate the debt to asset ratio in 2017 and 2018 based on the following information.
Total Assets in 2017
- Total assets in 2017 = Total current assets + Total non-current assets
- = $128,645 Mn + $246,674 Mn
- = $375,319 Mn
Total Assets in 2018
- Total assets in 2018 = $131,339 Mn +$234,386 Mn
- = $365,725 Mn
Total Debts in 2017
- Total debts in 2017 = Commercial paperCommercial PaperCommercial Paper is a money market instrument that is used to obtain short-term funding and is often issued by investment-grade banks and corporations in the form of a promissory note. + Term debt (current portion) + Term debt (non-current portion)
- = $11,977Mn + $6,496 Mn + $97,207 Mn
- = $115,680 Mn
Total Debts in 2018
- Total debts in 2018 = $11,964 Mn + $8,784 Mn + $93,735 Mn
- = $114,483 Mn
Using the above-calculated values, we will calculate Debt to assets for 2017 and 2018.
Calculation of Debt to Asset Ratio in 2017
- Ratio in 2017 = Total debts in 2017 / Total assets in 2017
- = $115,680 Mn / $375,319 Mn
The ratio in 2017 will be –
- = 0.308
Ratio in 2018
- Ratio in 2018 = $114,483Mn / $365,725 Mn
The ratio in 2018 will be –
- = 0.313
As the above explanations and examples explain very clearly, a high ratio is the result of high amount of debt which is beneficial but at the same time risky for the company since a large part of the revenue and profit will be used to pay interest. Thus if it is not able to earn enough profits, it may not be able to meet these obligations, thus putting pressure on its growth.
Companies whose nature is cyclical and cash flows fluctuate depending on market conditions or seasons, should keep debt within limits. Some examples are hotels, restaurants, airlines, automobiles, etc. So, as per the debt to asset ratio analysis, they should also avoid going for variable interest rates since it will be difficult to meet interest payments in case the business is suffering a downturn.
However, business which are defensive like pharmaceutical industry, which has demand throughout the year, may go for higher amount of debt because they have product demand and sales throughout the year, with a steady flow of cash to meet interest expense.
It is important to understand a good debt to asset ratio because creditors commonly use it to measure debt quantity in a company. It can also be used to assess the debt repayment ability of a company to check if the company is eligible for any additional loans. On the other hand, the ratio is being used by the investors to ensure that the company is solvent, will be able to meet its current and future obligations, and has the potential to generate a healthy return on its investment.
The debt to asset ratio analysis is typically used by investors, analysts, and creditors to assess a company’s overall risk. A company with a higher ratio indicates that company is more leveraged. Hence, it is considered a risky investment, and the banker might reject the loan request of such an entity. Further, if the ratio of a company increases steadily, it could indicate that a default is imminent at some point in the future.
The following inferences can be used as a guide to assess the financial health of a company:
- If the ratio is equal to one, then it means that all the company assets are funded by debt, which indicates high leverage.
- If the ratio is greater than one, then it means that the company has more debt in its books than assets. It is indicative of extremely high leverage.
- If the ratio is less than one, then it means that the company has more assets than debts and, as such, has the potential to meet its obligations by liquidating its assets if required.
Debt To Asset Ratio Vs Debt To Equity Ratio
Let us look at the differences between the above two topics.
- The former measures the proportion of debt to the total asset of the business whereas the latter shows the proportion of debt and equity in the capital structure of the business.
- The formula of the former is total debt divided by to tal asset whereas the formula of the latter is total debt divided by shareholder’s equity.
- Debt to equity includes only that part or financial liability in the calculation that is for the shareholders but the debt to asset takes into account all types of liabilities.
- The former measures the company’s liquidity level and the latter measures that solvency level.
Frequently Asked Questions (FAQs)
The organization can rely heavily on sales and revenue growth without rising related expenses. This increase in sales may lower the debt proportion and improve the debt-to-total assets ratio.
The ideal ratio depends on its industry, business model, growth prospects, profitability, and cash flow. In general, a lower debt-to-asset ratio is considered better. Therefore, a percentage of 0.5 or lower is considered healthy for many companies.
Debt-to-assets is a profitability ratio. The debt-to-asset ratio indicates the capacity to fulfill long-term debts. In comparison, the profitability ratio shows the income generation capacity. Therefore, the option must be improved.
This ratio decreases for various reasons, including an increase in assets, debt reduction, or a combination of an increase in assets and debt reductions.
This article has guide to Debt To Asset Ratio and its meaning. We explain its formula, interpretation and how to calculate with example. You may learn more about Financial Analysis from the following articles –
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