The debt-to-asset ratio of a company is one of the debt or leverage ratios included in the financial ratio analysis. The ratio of debt to assets shows how much total assets were purchased with borrowed money. This is represented by the debt on the balance sheet. It can be used to measure financial leverage and solvency. 1 Financial manager also uses it to gain critical insight into the firm’s financial health.
For example, if your company has a debt to asset ratio of 0.55 it means that some form of debt has provided 55% of all assets. If 55% of the firm’s operations are financed by debt, equity will finance the remaining 45%.
High debt-to-assets ratios could indicate that your company may have difficulty borrowing money or that the interest rate on money borrowed will be higher than if it had a lower ratio. Highly leveraged companies could be at risk of bankruptcy or insolvency depending on the industry and type. Certain industries may require more debt financing than others.
How to calculate the debt-to-asset ratio
Access to the balance sheet of the business is required to calculate the debt-to-asset ratio. This is a hypothetical balance sheet for XYZ.
|XYZ, Inc. December 31 Balance sheet (Millions Of Dollars)|
|Assets||2020||Liabilities and Equity||2020|
|Cash||$ 10||Accounts payable||$ 160|
|Marketable Securities||0||Notes are Payable||100|
|Receivables||175||Total Current Liabilities||260|
|Inventory||615||Bonds for the long-term||554|
|Total Current Assets||1000||Total Liabilities||814|
|Net Plant and Equipment||1000||Shareholder Equity||1186|
|Total assets||2000||Equity and Total Liabilities||2000|
To calculate the debt-to-asset ratio, follow these three steps. 2 All data comes from your balance sheet.
- For the calculation of the debt-to-asset ratio, you will need to look at the balance sheet. In particular, the liability side (right-hand side) of the balance sheet. Add the current liabilities to long-term debt.
- Take a look at the asset side (left hand) of the balance. Add the current assets to the net fixed assets.
- Divide step 1 (total liabilities/debt–TL) with step 2 (total assets/-TA). A percentage will be calculated. For Company XYZ Inc. this means that you have total liabilities of $814 million and total assets of $2,000.
For Company XYZ, that would be $814 million in total liabilities and $2,000 in total assets.
This means that 40% of your company’s debt financing is used, and 59% of your assets are financed either by equity financing or your investors.
Comparative Ratio Analysis
You can find the relevant meaning in the ratio results by comparing it with other years of ratio data from your firm using trend analyze or time series analysis. Trend analysis examines data from the balance sheet of a firm for several periods to determine if the ratio of debt-to-asset is changing, increasing, or staying the exact same. Trend analysis can provide valuable insight for the business owner and financial manager.
Industry analysis is the second type of comparative data analysis that you should do. To perform industry analysis, you will need to look at the ratio of debt-to-asset for firms in your industry. You can determine why your debt-to-asset ratio is different from others in your industry.
Why is the Debt-to-Asset Ratio Important for Businesses
High debt-to-asset ratios could put companies at risk, particularly if interest rates rise. High debt-to-asset ratios are a concern for creditors. This is especially true if interest rates rise. Some of the debt that the company owes may be called by creditors.
These conclusions are not necessarily supported by the investors. The firm may raise money via debt financing. Investors who own stock in the firm can maintain control and not increase their investment. The firm’s interest in the investors is magnified if it earns more from its borrowings than it pays in interest. But, investors also face greater risks.
Limitations on the Debt to Asset Ratio
The debt-to-assets ratio has its limitations. It is up to the business owner or financial manager to ensure that they are not comparing apples with apples. They must ensure that they are using industry averages when comparing debt-to-asset ratios of other firms in the industry.
In the numerator, for example, all the firms in an industry must use long-term or total debt. It is not possible to have firms that use total debt while others are using long-term debt. Your data will be corrupted, and you won’t get any useful data.
Another problem is the different accounting methods used by different businesses within an industry. Any comparisons will be invalid if some firms use one method of inventory accounting or depreciation, while others use different methods.
Financial managers and business managers must use their judgment to see beyond the numbers to obtain an accurate analysis of the debt-to-asset ratio.