What’s it: The debt-to-assets ratio is a leverage ratio to measure the extent to which a company depends on debt to finance its assets. We calculate it by dividing total debt by total assets.
Debt is a capital alternative to equity. When a company relies more on debt than equity, its financial leverage is higher. And it was considered risky because the company had to keep paying it off, even when it couldn’t generate revenue. And to pay it off, it requires sufficient and steady cash inflows.
As with other financial ratios, evaluating its trend over time helps us assess whether the company’s financial risk profile is improving or declining. Likewise, we can judge whether a company is taking on too much debt or not when comparing it to the industry average.
Why is the debt-to-asset ratio important?
Companies rely on capital to finance assets from two sources: equity capital and debt capital. Equity capital represents ownership, whereas debt capital represents obligations in which they have to pay interest and principal as per the agreement.
Say a company takes on debt by issuing bonds. In such cases, it must pay regular coupons, quarterly or semiannually, and pay off the principal when it is due. Long story short, debt creates liabilities and future cash outflows.
And the debt-to-asset ratio reveals how much a company depends on debt instead of equity. When it takes on too much debt, it can weaken its ability to pay off debt. Consequently, it has to spend more cash to pay interest and principal.
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The debt burden increases when interest rates rise. In addition, failure to generate sufficient cash flow from sales also weakens the company’s ability to pay. Those factors increase the default risk.
The higher the ratio, the more the company depends on debt from creditors. As a result, it reduces its financial flexibility because it needs to spend more money to pay off debt. Failure to pay can prompt creditors to file for bankruptcy against the company.
Analysts and creditors usually examine this ratio and compare it to peer companies or industry averages to evaluate how financially stable a company is. That helps them evaluate whether the debt levels are tolerable or already too high.
How to calculate the debt-to-asset ratio? What’s the formula?
Calculating the debt-to-asset ratio is easy. We only need arithmetic operations. The required data is also presented on the balance sheet. As the name suggests, we calculate it by dividing total debt by total assets. Here is the formula:
- Debt-to-assets ratio = Total debt / Total assets
Total assets include all company resources, including tangible and intangible assets, both short-term and long-term. Likewise, total debts also include short-term and long-term debt. The short-term debt matures within one year. Meanwhile, long-term debt must be settled in more than one year in the future.
The total debt I mean here is the total interest-bearing debt. Some people may use a liability instead of interest-bearing debt as the numerator, especially if the company has no interest-bearing debt (such as bank loans and bonds).
Now, take a simple example. A company reports total assets of $5.0 million on its balance sheet. And in the liability section, the company reports a debt of $3 million, consisting of short-term debt of $1 million and long-term debt of $2 million.
In this example, the company’s debt-to-asset ratio is 60% = $3 million / $5.0 million.
How to interpret the debt-to-asset ratio?
A good debt-to-assets ratio varies between businesses. Some consider ratios below 40% to be ideal. Meanwhile, a ratio above 60% is considered riskier.
A high ratio is less desirable because it implies a higher leverage level. Companies depend too much on debt to grow their assets than on equity. And, as I explained earlier, a debt must be paid even when revenue is zero. As a result, a high ratio increases their financial risk and uncertainty about debt repayment.
In contrast, a lower ratio indicates companies are less dependent on debt. With relatively low leverage, they have higher financial flexibility. So they can allocate more dollars of revenue to growing the business instead of paying interest or paying off the principal. Low leverage also tolerates companies taking on new debt to finance future growth.
Interpreting ratio according to context.
Interpreting this ratio requires us to compare it to the industry average. For example, a company has a high ratio. But, compared to other companies in the same industry, it is still in the average range. Thus, a high ratio may not be a material issue, and the company may be doing well financially.
Certain industries tend to have a high debt-to-asset ratio, such as the utility sector. While others do not.
Furthermore, we should also use this ratio along with other ratios when examining the overall financial health, especially concerning the company’s ability to pay. For example, some companies may have high ratios like those operating in the utility sector. Yet, they tend to have steady cash inflows. So, even though it has high leverage, it is accompanied by a good ability to pay.
Finally, we also need to examine the debt profile, including its tenor (short-term vs. long-term) and interest rate (floating vs. fixed). Take a relatively extreme case. The company has more short-term debt than long-term debt. In such cases, the company will have to spend a lot of money shortly, and if there is not enough cash inflow immediately, it can lead to problems.
In other cases, the company’s debt is mostly floating interest. In this case, an increase in policy rates will increase the company’s burden. Debt interest will increase following an increase in the benchmark rate.
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