There are many ratios and figures that you can examine to assess the overall financial health of a business. One of those is the debt to assets ratio. You might also hear it called the debt to equity ratio. So, what does this financial ratio actually mean and how might it affect your business? Analysts pay a lot of attention to this figure relative to other businesses in the same industry, and it can have a big effect on your bottom line. Many people wonder what this number represents and how it is calculated. Keep reading as we explain everything that you need to know about this important financial ratio.
What Is The Debt To Assets Ratio?
The debt to assets ratio is a leverage ratio that basically shows what percentage of a company’s assets are financed with debt. The higher this ratio, the more risk that investors see with that company. This ratio is not that difficult to calculate if you simply know the debt to asset ratio formula. Here is how you can calculate it. You will need to examine the company’s balance sheet to obtain the financial data that you need for the calculation. You will want to take the company’s total debt or total liabilities and divide that figure by the company’s total assets. This then shows you what percentage of the assets are funded with debt.
You will want to examine both short term debt and long term debt when calculating this figure. In addition, you should add in both tangible assets and intangible assets. If this number is too high compared to industry peers, then it might mean that the company’s debt obligations are too high. Investors will likely see the company as a financial risk because they may be unable to make their debt payments with even small changes in cash flow or interest rates. It is important to dive into a company’s financial statements and perform this analysis before making investing decisions.
Making Sense Of The Debt To Assets Ratio
Now that you have calculated the debt to assets ratio, how do you make sense of this metric? You know what it means, but is the total assets ratio that you calculated good or bad? This requires a little bit of ratio analysis. Whether the number is good or bad is somewhat relative, but here is what those numbers mean at a high level. If you calculate a ratio higher than 1, then this means that the company has more liabilities than assets. This equates to high debt relative to the amount of assets that the company owns. It signals that the company might have trouble paying its lenders in the future.
A ratio below one shows that a higher portion of the company’s assets are funded by equity. This generally means that the company’s leverage is lower; therefore, it could likely borrow money if necessary to fund additional projects or assets. It would have more financial flexibility than a company with higher financial leverage. These companies would generally be considered lower risk and potentially a better investment than companies with a higher ratio. The risk of default for a company with a lower ratio is lower. This means that lenders and investors can expect that repayment of the company’s loans should not be an issue.
How This Ratio Affects Businesses
The biggest way that this ratio affects businesses is by affecting the decisions of investors and affecting how easily the business can get additional credit or loans. Some people in corporate finance will simply want to look at the long-term debt to assets ratio while others will want to examine the current ratio. This takes into account all current liabilities including both short term and long term liabilities and compares it to total current assets. The total ratio is almost always higher because it adds in some additional debt that is not accounted for in the long-term ratio.
A business might be affected by being unable to secure additional credit because of its existing debt to asset ratio. If the ratio is too high, then lenders are unlikely to extend additional credit to the business. If they do, the interest rate may be much higher than the industry average. This means that the interest payments would be much higher leading to higher debt payments than the company would like. This can put the company in a bad financial position that can be difficult to recover from. In addition, investors likely see the company as extremely risky and are unlikely to invest funds in that company. For these reasons, it is extremely important that a company (both small businesses and larger corporations) not extend too much leverage when it comes to their total amount of debt.
The Debt To Asset Ratio & Your Personal Finances
So far, the conversation has been mostly about businesses. But the same conversation can be had when it comes to your personal finances as well. A ratio that is too high can signal to lenders that you are overextended when it comes to debt. In that case, they are unlikely to extend additional credit or, if they do, the interest rates will likely be much higher.
Another similar ratio that lenders examine when it comes to your personal finances is your debt to income ratio. This ratio examines how much of your gross income is already allocated to existing debt payments. Most lenders, especially when it comes to a mortgage, require that this ratio be less than 43% to qualify for a new loan. Keeping this ratio low is important so that you can acquire a loan in the future if necessary and secure a low interest rate when doing so.
The Bottom Line
The debt to assets ratio is a very common figure that financial analysts will observe when it comes to examining the overall health of a business. Businesses will generally want to keep this ratio as low as possible since a higher ratio can potentially signal financial trouble. A ratio higher than 1 is particularly troubling since it means that the company has more debt or liabilities than they do assets. If you are considering investing in a company, make sure that you do your homework and research their debt to assets ratio relative to their industry peers before making a decision.
Frequently Asked Questions
What is a good debt to asset ratio?
This varies by business and industry, but you generally will always want to see a ratio lower than 1. In most cases, a ratio lower than 0.5 is considered good. Anything higher than that might not signal immediate problems, but it could be an indication that the company is becoming overextended with liabilities.
What is the difference between debt and equity?
Debt is money that you owe to lenders or other people. Equity, on the other hand, means cash or assets that you own. Consider a simple example using your personal finances. Suppose you have a car loan of $20,000. This is a debt since you must make payments to repay that money to a lender. Now suppose that you own another car outright that is worth $10,000. That would be considered equity because it is an asset that you own and could leverage financially if the need arises.
What is the debt to asset ratio formula?
Many people wonder how to find the debt to asset ratio. The debt to asset ratio formula is quite simple. It is simply the company’s total debt divided by its total assets or equity. This is technically the total debt ratio formula. Some analysts prefer to only observe the long-term ratio. This means that only long-term liabilities like mortgages are included in the calculation. However, others prefer the overall ratio. This takes into account short-term liabilities like the power bill, a deferred tax liability, or other short-term monthly payments. The overall ratio is almost always higher than the long-term ratio.