Debt to Asset Ratio
It shows an investor how much percentage of a company's assets is financed by debt.
In simple terms, it represents what percentage of assets owned by a company is financed or supported by debt funds. Essentially it is an important factor looked at by an investor before investing in a company.
The high Debt to asset ratio shows the investors that the company has a lot of financial assets backed by debt which is much riskier to invest in as the company may fail to repay its liabilities and soon go bankrupt.
The ratio may vary according to the industry and the company’s business model. For example, companies that require high infrastructure will have high amounts of debt as they need to invest in building and maintaining the infrastructure.
Towards the other scale spectrum, companies that do not require much capital-intensive infrastructure will have a lower debt-to-asset ratio. An example would be software development firms.
Key Takeaways
- The debt-to-asset ratio shows an investor how much percentage of a company's assets is financed by debt.
- It is an important ratio taken into consideration by creditors and investors to assess a company’s financial risk.
- A high debt-to-asset ratio signals to the market that the company’s cash flow is less and the company is in a highly vulnerable state.
- Companies that have highly capital-intensive infrastructure usually have a higher debt-to-asset ratio.
- It can also be used to assess the financial stability of a company and how external factors like a rise in interest rate may affect the company.
- Although debt to asset is a very important factor, it is just not only a factor to rely upon.
Debt To Asset Ratio Formula
The formula to calculate the debt-to-asset ratio is:
The Debt to asset ratio = Total liabilities / Total assets
1. Estimating total debts
In the world of corporate finance, liabilities like utility bills, payroll expenses, and accounts payable, and long-term liabilities like pensions payable are part of the business but do not account for debt.
2. Estimating assets
It is much easier. It includes companies with all intangible and tangible assets like equipment, merchandise, Goodwill of the firm, and copyrights.
Importance of debt to asset ratio
It can show a lot about an organization's capital structure. A debt ratio higher than 1 shows that a huge amount of debt funds the financials of the company. This is a red signal to the company as a rise in interest rate will damage the financials of the company.
If central banks decide to raise interest rates, business firms will have to allocate more of their resources to cover the increased interest payments.
In the case of a lower debt-to-asset ratio, the company signals that its asset side is much more than its liabilities side. This gives the small-scale company financial flexibility in terms of aggressively expanding its business.
To further break it down, we will use an illustration. Suppose there are two start-up businesses, “A” and “B,” one with a higher Debt to asset ratio and the other one with a lower debt-to-asset ratio.
After starting operations, both businesses are performing well and are now thinking of expanding their business. In the case of firm A, it can further take loans to fund its needs for funds to expand as it has a lower debt ratio, and banks will be willing to provide loans.
In case firm B Banks will not prefer to fund its expansion as the company already has a sufficient amount of debts, and the bank may not recover any further debts.
Let's assume both have sufficient funds to expand, and while both companies are thinking of expanding, the country's central bank decides to hike interest rates.
In such a case, firm A may still decide to expand, but firm B will have to rethink its expansion as a large number of its funds will now be diverted to paying its interest rates.
Nevertheless, businesses with greater capital needs may exhibit significantly elevated debt-to-asset ratios due to the unique characteristics of their operational models. This is particularly evident in sectors such as utilities and telecommunications.
What does the debt-to-asset ratio indicate?
It may show a lot about a company. Some of the common derivations from debt to asset ratio are defined below:
1. The financial risk of the firm
The ratio is usually used to compute the level of financial risk associated with a company by looking into its total assets against its total liabilities.
As discussed previously in the article, an organization with a ratio exceeding 0.5 is deemed unsuitable for investment due to its lack of safety for investors.
Having a healthy debt-to-asset ratio will help attract a large volume of investments. It is an important ratio investors look for.
2. The capital structure of the firm
A debt-to-asset ratio speaks a lot about a firm's capital structure and how a firm is using investors' money and allocating funds. A higher debt-to-asset ratio would mean that the company is relying more on funds which are from debt sources.
3. Liquidity
The ratio also helps in assessing a company's liquidity position. A higher debt-to-asset ratio may show that the company is taking debts to fulfill its cash requirements and is running low on cash flows.
NOTE
Maintaining healthy liquidity helps the company for easier cash flow. With a good cash flow, a company can easily navigate the financial crisis by using immediately available cash funds.
4. Measuring tool
It can be used to measure two or more companies' performance in the same industry and may help investors make a wise decision on which company to invest in.
Although only relying on this ratio is of no use. Using this ratio with a combination of other ratios may help increase investors' predictability.
NOTE
A debt-to-asset ratio signals much more than the listed items; these are only a few of many examples that are listed. It is also important to note that a debt-to-asset ratio approaching 1 (100%) is a very high proportion of debt financing. A company cannot sustain its current operations in such a case.
Some companies which have high debt-to-asset ratios are Moody’s Corp, Lamb Weston Holdings Inc, Lowe's Company Inc, Alliance Data System Corp, and many more.
Debt to Asset Ratio vs Debt to Equity Ratio
The debt-to-asset ratio is the ratio between a company’s liabilities and assets. On the other hand, the debt-to-equity ratio has equity in its denominator.
Although both financial metrics measure a company's leverage, they indicate different scenarios.
The debt-to-asset ratio provides a much more focused view of companies debt as it takes only the liabilities of a company into account.
Debt to asset ratio is calculated by:
Debt to equity = Total liabilities / Total equity
Where total liabilities are the debt or liabilities of a company, and equity refers to the residual value of the company’s assets after deducting liabilities.
In debt to equity ratio, it indicates debt in proportion with only equity, whereas, in debt to asset ratio, it indicates debt with entire assets, including intangible assets.
Financial analysts record and interpret the debt-to-asset ratio data with time series. This phenomenon is referred to as a trend line, and a gradual upward trend in the trend line indicates that the company is reluctant to fulfill its financial debts.
In the case of debt to asset ratio, it is usually used by creditors and investors to check the amount of financial risk of investment in a company.
Here high leverage means that a company uses its debt funds to run its operations. If a company has a high potential to grow, it may be able to manage with high debt finance to finance itself initially.
But if the company is financially weakened, it may not be able to sustain such high debts and might collapse going further.
The evaluation of such ratios depends on the specific industry in which the company operates. In certain instances, a company can maintain a high debt-to-asset ratio and successfully fulfill its financial obligations while operating smoothly.
Conversely, there are situations where a company may possess a low debt-to-asset ratio but encounter difficulties in managing its financial debts.
Problems with Debt-to-Asset Ratio
Debt to asset ratio, although an important ratio, has its limitations. Anyone comparing the ratios to conclude must also consider that both the companies being compared must take the same thing in the numerator and denominator.
Another issue to consider is that companies follow different cost methods, Inventory management systems, and several different methods for the computation of depreciation.
Because of such widespread practices, each will result in a different debt-to-asset ratio; hence, a comparison of debt-to-asset ratio may not be accurate.
Hence standardization of numerators and denominators across the industry is impossible, and hence the entire purpose of such a comparison fails.
So to overcome such vast irregularities and properly compare companies, one should always check with the industry average and try to look at more than just the numbers. While comparing companies, people should use multiple financial metrics to get a proper insight.
Furthermore, companies with higher debt-to-asset ratios encounter an issue of limited access to capital from the market, as investors typically seek lower ratios. Moreover, banks are unlikely to extend further financial assistance to such companies.
Hence some highly capital-intensive companies, like the petroleum industry, find it difficult to raise funds.
In such cases, investors also understand the industry's risk and return policy and try to judge the industry's average debt-to-asset ratio.
Further, breaking it down, one can not assess the asset quality that is being considered for computing the debt-to-asset ratio. As it considers intangible assets, it is difficult to prove an intangible asset such as the goodwill of a company.
The valuation modeling course by WSO will further enhance your ability to understand and map ratios and use them to plot trend lines and gain insights into different ratios.
Debt to Asset Ratio FAQ
Usually, creditors look for a low debt-to-asset ratio as it signals better financial stability of the company than any other company having a higher ratio.
A 0.5 debt-to-asset ratio is an alarming bell for a company; it shows that debts finance 50% of its assets and is usually an indication that the company will soon default on its payment.
This question has no fixed answer, as the optimal ratio varies across industries. It is important to examine the industry average and then determine what constitutes a favorable debt-to-asset ratio.
Not always, as discussed, capital-intensive capital companies usually have high debt-to-asset ratios and still function normally.
It becomes reliable when combined with other ratios and compared with the industry average. Although only relying on debt to asset ratio is not recommended.
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