The debt to asset ratio is a measure that estimates how much of a company’s assets are financed through debt. It is an important metric that helps in determining the financial structure of a company, which is simply a breakdown of how its assets were financed, either through debt, equity or a mix.
The debt-to-assets ratio is expressed as a percentage of total assets and it commonly includes all the business’ recorded liabilities.
What is the Debt to Asset Ratio?
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Also known as the D/A ratio, the debt-to-assets metric helps analysts, investors and lenders in understanding how leveraged a company is. The higher the proportion of debt in relation to assets, the higher the leverage, and in consequence, the higher the risk of such business.
The reason why it is seen as risky is due to the fact that equity doesn’t have to be repaid to shareholders, as they have risked their money understanding that the success of their investment is based on the success of the business. On the other hand, lenders and debt-holders are entitled to a set of payments and they expect to receive them as promised. Failing to do so, will eventually lead the business to bankruptcy.
A company with a high D/A ratio will eventually take a penalty on its value, as the risk of default is higher than that of a company with 0 leverage.
Debt to Asset Ratio Formula
The debt to asset ratio formula calculation fairly simple:
D/A = Total Liabilities (Short Term + Long Term) / Total Assets
Debt to Asset Equation Components
Total Liabilities: The sum of all financial obligations listed on the Balance Sheet on the Liabilities side. Both short-term and long-term.
Total Assets: The sum of all the company’s assets, including current, fixed and other assets, as listed in the Balance Sheet.
There may be some variations to this formula depending on who’s doing the analysis. Some analysts exclude current liabilities and current assets as those are part of the business’ working capital and only estimate the debt-to-assets ratio considering fixed and other assets along with only long term liabilities. In any case, the important thing is that the extent of how leveraged the company is can be assessed.
Debt to Assets Example
Light Generators is a company that manufactures power generators for recreational and industrial uses. The business is publicly traded and it has been operating for more than 10 years. The market currently sees this business as a highly risky one as it is too leveraged. Yet, the company’s managers see this leverage as an opportunity to grow the business, as they have many profitable projects where they can allocate the borrowed funds.
In any case, here’s Light Generators’ financial information, which is what analysts employ to determine how leveraged the company is
Current Assets: $5,700,000
Net Fixed Assets: $14,570,000
Other Assets: $1,250,000
Total Assets: $21,520,000
Short-Term Liabilities: $4,560,000
Long-Term Liabilities: $11,650,000
Total Liabilities: $16,210,000
Using this information, we can estimate the debt-to-assets ratio:
D/A = $16,210,000 / $21,520,000 = 75.33%
Under any scenario, a 75% debt-to-asset ratio is high and risky. If the company faces any significant loses in the short term the business may not be able to sustain itself and it will go bankrupt. Therefore, even though the management team thinks this is something beneficial for the business, it actually puts the business in a sensitive position.
Debt to Asset Ratio Analysis
Analyzing how leveraged a company is particularly important when it comes to determining its long-term sustainability. A highly indebted business has less capacity to deal with market downturns and negative outcomes on the projects it is involved with.
On the other hand, there’s no one-size-fits-all debt-to-assets ratio. Different industries demand different degrees of leverage to function profitably. For example, capital intensive businesses, those that have to constantly invest in fixed assets to sustain their operations, are usually more leveraged than software businesses, as the cost of debt is cheaper than the cost of equity and the only way to operate profitably is to finance a big portion of those fixed assets with debt.
There are many reasons why the cost of debt is cheaper. First, interest payments are tax deductible and secondly, since debt-holders have a higher claim than equity-holders, they are willing to receive a lower rate of return. This means that a company with a D/A ratio of 0 may be losing the opportunity to expand its business safely by adding some debt to its Balance Sheet.
Therefore, the only way to understand if a debt-to-assets ratio is healthy for a business or not is to compare it with other companies in the same industry to understand how other businesses within that industry fund themselves. On the other hand, it is also important to incorporate some other debt-related metrics to the analysis such as the Debt Service Coverage Ratio, the Debt to Equity ratio and the Interest Coverage Ratio.
Debt to Asset Uses, Cautions, & Pitfalls
As discussed previously, one of the main issues with analyzing the debt-to-assets ratio isolated from other metrics and from appropriate benchmarks is that it leads to conclusions that may not be fully accurate.
Operating with a high degree of leverage may be what it takes to make a certain business profitable. While this structure may not be appropriate for other businesses, it may be for that one. Therefore, it is essential for the purpose of analyzing a company’s financial health that the D/A ratio is analyzed along with industry benchmarks.
That said, any debt-to-assets ratio higher than 50% should call for an explanation as a company that finances more than 50% of its assets with debt should outline the reasons why it has decided to operate under such risky position and how it plans to cover for both principal and interest payments. In some cases, the debt-to-assets ratio may go down for a certain period of time, as big projects are being developed, yet, the situation may be normalized after those have been completed.
In any instance, the degree of risk that debt carries must not be underestimated, and the management team should be in a position to clarify its strategy to deal with a heavy burden of debt, if it exists.