What is Debt to Asset Ratio?
The debt to asset ratio shows what percentage of a company’s assets are financed by debt rather than equity. The ratio is used to assess a company’s financial risk. It essentially depicts how a business has grown and acquired assets over time. Companies can raise capital by attracting investors, making profits to buy their own assets, or accumulating debt. In most circumstances, the first two are obviously preferable.
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It examines how much of the company’s resources are owned by shareholders in the form of equity and creditors in the form of debt to determine how leveraged the company is. This ratio is used by both creditors and investors to make business decisions.
Debt to Asset Ratio Formula
Debt to Assets Ratio = Total Liabilities / Total Assets
Modified Debt to Assets Ratio = Total Liabilities / Total Tangible Assets
How to Calculate Debt to Assets Ratio?
The following illustration demonstrates the calculation of Debt to Assets Ratio using both the methods.
|Tangible Assets||Rs 12,00,000|
|Intangible Assets||Rs 6,00,000|
|Short Term Liabilities||Rs 4,00,000|
|Long Term Liabilities||Rs 7,00,000|
(Tangible Assets + Intangible Assets)
(Rs 12,00,000 + Rs 6,00,000)
(Short Term Liabilities + Long Term Liabilities)
(Rs 4,00,000 + Rs 7,00,000)
|Debt to Assets Ratio|
(Total Liabilities / Total Assets)
(Rs 11,00,000 / Rs 18,00,000)
Since the ratio is less than 1, it suggests that the company has debts 0.61 times of its assets.
|Modified Debt to Assets Ratio|
(Total Liabilities / Total Tangible Assets)
(Rs 11,00,000 / Rs 12,00,000)
With the modified ratio, the company has funded its debts by its assets 0.92 times.
This ratio is quite near to 1.
With just Rs 1,00,000 more in liabilities and no change in assets, the company will just be able to fund its liabilities with no surplus.
However, many other factors must be considered along with other ratio analysis
Uses of Debt to Assets Ratio
Investors want to know that the company is solvent. The company must have enough funds to cover its existing obligations and is profitable enough to pay them back. Creditors, on the other hand, are interested in knowing how much debt the company currently. This is because they are concerned about collateral and repayment ability. If the company has already leveraged all of its assets and is already struggling to make its monthly payments, the lender is unlikely to grant extra loans.
You can also check our article on What is Operating Profit Ratio?
Interpretation of Debt to Assets Ratio
A high ratio suggests that debt is used to fund a significant share of assets. On the other hand, a low ratio indicates that equity is used to fund the majority of assets.
A ratio equal to 1 indicates that the company’s liabilities are equal to its assets. It implies that the business is extremely leveraged. If the ratio is less than 1, the company has more assets than liabilities. The company can fund its liabilities by selling assets if need be. The lower the debt-to-asset ratio, the better it is for the company.
A ratio greater than 1 also implies that a company is putting itself at risk of not being able to repay its obligations. Such a risk is particularly worrisome if the company is in a highly cyclical industry with fluctuating cash flows. If a company’s debt is liable to rapid rises in interest rates, as is the case with variable-rate debt, it may be at risk of default.
Analysts must track the debt to asset ratio on a trend line over a period. A rising trend implies that a company is reluctant or unable to pay off its debt. This rising trend could lead to a default and possible insolvency in the future.
Lenders may impose contractual terms that drive excess cash flow into debt repayment and limits on alternate uses of funds. Moreover, with a strong hold, investors may add a to infuse additional equity into the company to address this issue. Such extreme measures by investors and lenders are common under the circumstances of continuous default and near threat of insolvency.
Learn: Types of Ratio Analysis
Limitation of Using Debt to Assets Ratio
The Debt to Assets Ratio does not provide an analysis of asset quality and reliability. It takes into consideration all tangible and intangible assets while calculating the ratio. The intangible assets include goodwill, patent, trademarks, and so on. Such assets are either valued by third party agencies or by the company. Such valuation of these intangible assets could be overvalued or undervalued. These valuations directly impact the ratio and its interpretation. Hence, it is prudent to understand each line item under the heading assets in the balance sheet and its valuation methods.
The Debt to Assets Ratio considers total debts outstanding. While considering the total debts, the ratio disregards the due date for payment of these debts, the settlement factors, and contractual terms. Many debts might not have a due payment in the near future and the company might have plans to fund its debt as and when they mature for payment.
For example- a company might have taken a loan for expansion which is due to repayment or interest payment after 5 years. The company plans to fund these payments with its increased revenue streams. Another example of such a situation is wherein the settlement and contractual terms result in a renegotiation of the loan amount. Many banks provide a renegotiation of these terms and provide either a longer payment schedule or lower the loan amount in exchange for higher interest rates or immediate payments. These terms result in lowering the ratio.