Many ratios and figures can be examined to assess a business’s overall financial health. One of those is the debt-to-assets ratio, which you might also hear called the debt-to-equity ratio. So, what does this financial ratio 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, which can significantly affect your bottom line. Many people wonder what this number represents and how it is calculated. Keep reading as we explain everything you need about this important financial ratio.
What Is The Debt To Assets Ratio?
The debt-to-assets ratio is a leverage ratio that shows the percentage of a company’s assets financed with debt. The higher this ratio, the more risk investors see with that company. This ratio is not that difficult to calculate if you know the debt to asset ratio formula.
The Formula
Here is how you can calculate it. You must examine the company’s balance sheet to obtain the financial data needed 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.
Account for All Debt and Assets
When calculating this figure, you will want to examine both short-term and long-term debt. 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 it may be unable to make its debt payments with even small changes in cash flow or interest rates. It is important to examine a company’s financial statements and perform this analysis before making investing decisions.
KEY TAKEAWAYS
- The debt-to-asset ratio evaluates a company’s or individual’s financial health and helps determine their leverage.
- A calculation ratio above 1 means the company has more liabilities than assets. It signals that the company/individual might have trouble paying its lenders.
- If the debt-to-asset ratio is too high, it might be challenging to get financing or investors.
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 ratio of the total assets that you calculated good or bad? This requires a little bit of ratio analysis.
Analyzing the Ratio
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 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. A company with a lower ratio has a lower risk of default, which means that lenders and investors can expect that repayment of the company’s loans should not be an issue.
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How This Ratio Affects Businesses
Decisions to Invest in the Company
This ratio affects businesses by affecting investors’ decisions and how easily the company 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 ratio takes into account all current liabilities, including both short-term and long-term liabilities, and compares them to total current assets. The total ratio is almost always higher because it adds additional debt that is not accounted for in the long-term ratio.
Ability to Secure Credit
A business might be affected by being unable to secure additional credit because of its existing debt-to-asset ratio. Lenders are unlikely to extend further credit to the company if the ratio is too high. If they do, the interest rate may be higher than the industry average. This means the interest payments would be much higher, leading to higher debt payments than the company would like.
Higher debt payments 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 it. For these reasons, it is extremely important that companies (both small businesses and larger corporations) not extend too much leverage when it comes to their total debt.
TIP
Mortgage lenders typically want individuals to have a debt-to-income ratio below 43% to qualify for a loan. Keeping your ratio low provides you with greater options for securing a low-interest loan.
The Debt To Asset Ratio & Your Personal Finances
So far, the conversation has been mostly about businesses. But the same discussion can be had when it comes to your 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; if they do, the interest rates will likely be much higher.
Another similar ratio that lenders examine when it comes to your 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 regarding a mortgage, require this ratio to be less than 43% to qualify for a new loan. Keeping this ratio low is vital 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 observe when examining a business’s overall health. Businesses 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 assets. If you are considering investing in a company, make sure that you do your homework and research its debt-to-assets ratio relative to its industry peers before making a decision.
Frequently Asked Questions
This varies by business and industry, but you will generally 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 indicate that the company is becoming overextended with liabilities.
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 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 you own and could be leveraged financially if needed.
Many people wonder how to find the debt-to-asset ratio. The formula is quite simple: The company’s total debt is divided by its total assets or equity. This is technically the total debt ratio formula. Some analysts prefer only to 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 considers 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.
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