A company's debt-to-asset ratio is one of the groups of debt or leverage ratios that is included in financial ratio analysis. The debt-to-asset ratio shows the percentage of total assets that were paid for with borrowed money, represented by debt on the business firm's balance sheet. It is an indicator of financial leverage or a measure of solvency. It also gives financial managers critical insight into a firm's financial health or distress.
If, for instance, your company has a debt-to-asset ratio of 0.55, it means some form of debt has supplied 55% of every dollar of your company's assets. If the debt has financed 55% of your firm's operations, then equity has financed the remaining 45%.
A high debt-to-assets ratio could mean that your 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. Highly leveraged companies may be putting themselves at risk of insolvency or bankruptcy depending upon the type of company and industry. Some industries can use more debt financing than others.
The debt-to-asset ratio represents the percentage of total debt financing the firm uses as compared to the percentage of the firm's total assets. It helps you see how much of your company assets were financed using debt financing.
How to Calculate the Debt-to-Asset Ratio
In order to calculate the business firm's debt-to-asset ratio, you need to have access to the business firm's balance sheet. Here is a hypothetical balance sheet for XYZ company:
|XYZ, Inc. December 31 Balance Sheet (Millions of Dollars)|
|Assets||2020||Liabilities and Equity||2020|
|Cash||$ 10||Accounts Payable||$ 160|
|Marketable Securities||0||Notes Payable||100|
|Accounts Receivable||175||Total Current Liabilities||260|
|Total Current Assets||1000||Total Liabilities||814|
|Net Plant and Equipment||1000||Shareholder Equity||1186|
|Total Assets||2000||Total Liabilities and Equity||2000|
Take the following three steps to calculate the debt to asset ratio. All information comes from your company's balance sheet.
- To calculate the debt-to-asset ratio, look at the firm's balance sheet, specifically, the liability (right-hand) side of the balance sheet. Add together the current liabilities and long-term debt.
- Look at the asset side (left-hand) of the balance sheet. Add together the current assets and the net fixed assets.
- Divide the result from step one (total liabilities or debt—TL) by the result from step two (total assets—TA). You will get a percentage. In this example for Company XYZ Inc., you have total liabilities (debt) of $814 million and total assets of $2,000.
So with Company XYZ, we would look at $814 million in total liabilities divided by $2,000 in total assets:
- Debt-to-Assets = 814 / 2000 = 40.7%
This tells you that 40.7% of your firm is financed by debt financing and 59.3% of your firm's assets are financed by your investors or by equity financing.
Comparative Ratio Analysis
To find relevant meaning in the ratio result, compare it with other years of ratio data for your firm using trend analysis or time-series analysis. Trend analysis is looking at the data from the firm's balance sheet for several time periods and determining if the debt-to-asset ratio is increasing, decreasing, or staying the same. The business owner or financial manager can gain a lot of insight into the firm's financial leverage through trend analysis.
The second comparative data analysis you should perform is industry analysis. In order to perform industry analysis, you look at the debt-to-asset ratio for other firms in your industry. If your debt-to-asset ratio is not similar, you try to determine why.
Why the Debt-to-Asset Ratio Is Important for Business
Companies with high debt-to-asset ratios may be at risk, especially if interest rates are increasing. Creditors prefer low debt-to-asset ratios because the lower the ratio, the more equity financing there is which serves as a cushion against creditors' losses if the firm goes bankrupt. Creditors get concerned if the company carries a large percentage of debt. They may even call some of the debt the company owes them.
More equity financing, or owner-supplied funds, than debt financing means lower firm risk and a margin of safety for the firm and its creditors
Investors in the firm don't necessarily agree with these conclusions. If the firm raises money through debt financing, the investors who hold the stock of the firm maintain their control without increasing their investment. Investors' returns are magnified when the firm earns more on the investments it makes with borrowed money than it pays in interest. However, the investor's risks are also magnified.
Limitations of the Debt-to-Asset Ratio
There are limitations when using the debt-to-assets ratio. The business owner or financial manager has to make sure that they are comparing apples to apples. In other words, if they are doing industry averages, they have to be sure that the other firm's in the industry to which they are comparing their debt-to-asset ratios are using the same terms in the numerator and denominator of the equation.
For example, in the numerator of the equation, all of the firms in the industry must use either total debt or long-term debt. You can't have some firms using total debt and other firms using just long-term debt or your data will be corrupted and you will get no helpful data.
Another issue is the use of different accounting practices by different businesses in an industry. If some of the firms use one inventory accounting method or one depreciation method and other firms use other methods, then any comparison will not be valid.
Business managers and financial managers have to use good judgment and look beyond the numbers in order to get an accurate debt-to-asset ratio analysis.
- The debt-to-asset ratio is a measure of a business firm's financial leverage or solvency.
- The debt-to-asset ratio determines the percentage of debt the business firm uses to finance its operations.
- The debt-to-asset ratio is not useful unless you have comparative data such as you get through trend or industry analysis.
- The debt-to-asset ratio is important for business creditors so they will know how much cushion they have against risk.
- Business owners and managers have to use good judgment in analyzing the debt-to-assets ratio, not just strictly the numbers.