The Long-Term Debt to Asset Ratio is a metric that tracks the portion of a company’s total assets that are financed through long term debt. This ratio allows analysts and investors to understand how leveraged a company is.
What is the Long Term Debt to Assets Ratio?
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Understanding the degree in which a company relies on debt to grow is particularly important for investors to assess a business potential risks. The more leveraged a company the more sensitive it will be to potential market and sales downturns that negatively affect its capacity to fulfill its financial commitments. On the other hand, a company that continues to grow over time and needs little debt to do so will be highly valued by the market.
The Long Term Debt to Assets ratio provides a clear picture of how leveraged a business is, by analyzing the percentage of its assets that are currently funded trough debt. If the business is progressively increasing its Long Term Debt to Assets ratio, its growth model or strategy may be categorized as too risky or unsustainable over time.
Long-Term Debt to Asset Ratio Formula
The long term debt to asset formula is calculated like this:
LTD / A = Long Term Liabilities / Total Assets
LT Debt to Asset Equation Components
Long Term Liabilities: The sum of all debts that have a maturity date or due date beyond the next 12 months.
Total Assets: The sum of all current assets, other assets and fixed assets.
The ratio can be expressed either in decimals or as a percentage.
An alternative ratio known as the Long Term Debts to Fixed Assets can be also employed as a way to estimate how much of the business’ fixed assets are financed through long term debt. The higher the percentage of that ratio is the easier it is to understand the destination and purpose of the leverage.
Long Term Debt to Asset Example
Goliath Electronics is a business that manufactures household appliances and electronic devices. The company is publicly traded and currently it has a market capitalization of $6,430,000,000. Recently the business has been expanding itself and as part of this effort it sold a $2,225,000,000 bond issue to finance its growth.
Analysts are worried about this move as they suspect the business may be increasing its leverage significantly. The company’s Balance Sheet shows the following information:
- Current Assets – $2,504,000,000
- Fixed Assets – $5,431,000,000
- Other Assets $254,000,000
Total Assets: $8,189,000,000
- Short Term Liabilities – $1,843,000,000
- Long Term Liabilities – $3,120,000,000
Total Liabilities: $4,963,000,000
With this information we can determine the Long Term Debt to Assets ratio as follows:
LTD / A = $3,120,000,000 / $8,189,000,000 = 38.1%
The company has stated that 100% of these funds will be employed to build new factories and develop a chain of stores worldwide to strengthen the brand presence on each country. With the addition of this new bond, the ratio will increase. By adding the new amount of Long Term Debt to the calculation, the ratio will end up at:
LTD / A = ($3,120,000,000 + $2,225,000,000) / ($8,189,000,000 + $2,225,000,000) = 51.3%
As a result, the business leverage will increase significantly, which means the company will be in a much more sensitive position if its sales decline or if they face obstacles to develop these projects, or if the expected profitability of those is lower than the company’s estimations.
Long-Term Debt to Asset Ratio Analysis
A Long Term Debt to Assets ratio may fluctuate between 0 and 1 (in decimals) or between 0% and 100%. The higher the ratio, the more leveraged a company is. While a ratio of 0.5 (50%) or less is usually considered healthy, other important metrics must be evaluated in order to determine if the level of leverage is actually sustainable.
These additional metrics include the Interest Coverage Ratio, the Fixed Charges Coverage Ratio and the Total Debt Coverage Ratio. By analyzing all these ratios combined it will be easier to understand what’s the current situation of the company in relation to its debt.
Furthermore, understanding the purpose and destination of the borrowed funds is as important as determining the ratio itself. By calculating the Long Term Debt to Fixed Assets Ratio, an investor can understand the portion of the Long Term Debt that may be employed to finance the business’ Fixed Assets. While it is common that businesses issue debt to finance their capital expenditures, the fact that these funds are committed to assets that will be hard to turn into cash quickly, a high Long Term Debt to Fixed Assets ratio indicates an increased risk of insolvency if the projects or the fixed assets themselves turn out to be less productive than expected.
In turn, a company that finances its current assets with long term debt is in a better position to quickly turn these assets into cash to pay for its obligations, as current assets are highly liquid compared to fixed assets.
In the case of Goliath Electronics, the company cited above as an example, the increase in its Long Term Debt to Assets ratio indicates that the business is moving itself to a riskier position. If the projects were to fail or if their performance is poorer than expected, the business will find itself affected by the consequences of an unproductive debt. This occurs when a business invests, say a $1,000,000 in fixed assets that do not perform as expected and they are obligated to sell them at a portion of their historical cost, which obligates the business to recognize a loss in the sell of the asset and therefore it cuts the cash flow that will supposedly pay for the debt’s principal when it matures.
Long Term Debt to Assets Uses, Cautions, Pitfalls
The way a business values its fixed assets is particularly important to avoid under or overestimating the Long Term Debt to Assets ratio. While in the books, a business may have recorded a given historical value of its fixed assets, their current market value may be much lower or higher than that. For this reason, in order to have a more realistic picture of how leveraged a business is, some analysts dig deeper into the books to find the most valuable assets a business owes in order to re-assess their value and estimate the Long Term Debt to Assets ratio based on the current market value of the largest assets.