The debt to asset ratio is a key metric to understand how indebted a company is compared to the assets held. The ratio is a measure of leverage included in a company’s financial analysis. Below, we’ll describe in detail everything you need to know about this critical metric of a company’s financial health.
What Is the Debt to Asset Ratio?
The debt to asset ratio calculates the percentage of company assets that were purchased using debt.It is also a measure of the financial solvency or health of a business. The higher the debt level compared to assets, the greater the risk of a company not being able to meet its commitments.
Financial managers use this information to gain critical insight into the financial state of a company.For example, a company with a debt to asset ratio of 0.60 indicates the company has financed 60 percent of every dollar the company holds in assets. The remaining 40 percent of assets are therefore financed by equity.
A company that has a very high ratio may find it difficult to obtain new loans or may be obligated to pay higher interest rates squeezing the company’s profit margins. Higher debt to asset ratios may also mean the company can be at risk of insolvency.
However, each industry or sector has different considerations as to what may be high debt to asset ratios. A lot depends on how the company was set up and how the leverage was obtained. Often real estate enterprises have a high debt to asset ratio early on in life, as they tend to issue large amounts of bonds.
As the construction project advances to the later stages and sales are generated that ratio falls dramatically and quickly. While investors and analysts of other sectors would see such high debt to asset ratios as a warning sign that something is wrong, in real estate it’s business as usual.
- Debt to asset ratios measure the company’s financial leverage or solvency.
- The ratio indicates the percentage of debt the firm uses to finance its operations compared to total assets.
- The debt to asset ratio is only useful when you have comparative data from trend and industry analysis.
- For creditors, the debt to asset ratio is important to understand how much risk they take on by financing the company.
- Companies must use good judgment based on experience within the industry, future projections of cash flow, and sales generation to analyze the debt to asset ratio. Not just by strictly observing a specific level.
- The debt to asset ratio is often known as the liabilities to assets ratio.
How to Calculate Debt to asset Ratio
To calculate a firm’s debt to asset ratio you need to have access to its balance sheet. The image below is an example of the balance sheet for General Motors as published by Yahoo Finance. We need the two numbers from the first two rows: Total Assets and Total Liabilities:
When the balance sheet is not so clearly presented as in the case above, liabilities will appear in an itemized column under the label Liabilities, while Assets will also appear in an itemized column. In this case, you would add all the items under each column to reach a final number as in the image above.
Once you have the final numbers for total assets and total liabilities, you divide liabilities by assets. And this is the percentage of debt compared to the company’s total assets. Using data from the table above for the year 2021, we see that total assets equal $244.7 billion, and liabilities equal $178.9 billion.
Dividing 178.9 by 244.7 we get a debt to asset ratio of 0.731. The ratio means that 73.1 percent of General Motors’ operations are financed through debt.
Giving Meaning to the Debt to Asset Ratio
The ratio we calculated above would seem high simply through instinct. However, it’s important to relate this number to the industry average and the underlying trend for the ratio. Calculating the industry average is beyond the scope of this article.
However, with the information above you can calculate the trend of the debt to asset ratios for General Motors over the last four years. The table below shows a continuously decreasing debt to assets ratio from 2018 through 2021.
Why the Debt to Asset Ratio Is Important
Creditors and investors alike are concerned with the debt to asset ratio of a company. Before a creditor gives a loan or purchases a company’s bonds, they will want to have confidence that the company has a large enough cushion in terms of assets.
If debts by far outweigh assets, in the case of bankruptcy, it will be harder for creditors to regain as much of their capital as possible. Larger amounts of total assets mean that creditors are more confident if they must make a call for their capital to be returned.
The perspective changes slightly with the company’s shareholders. They may see a high debt to asset ratio as a risk. However, they also know they are already at full risk as shareholders get paid last in a bankruptcy.
So, it may be tempting for shareholders to take on more risk through external debt. This increases the debt to asset ratio but without creating further risk for the current shareholders.
What the Debt to Asset Ratio Can’t Do
When analyzing the Debt to asset ratios of a firm, one size does not fit all. As mentioned earlier, debt to asset ratios must be analyzed by looking at the trend of the ratio and in comparison, with industry peers.
However, you must compare similar calculation methods to have a meaningful analysis. Some companies use varying accounting practices when determining the liabilities to use in the debt to asset ratio. If you compare a company using total debt against a company that is using only long-term debt, then the comparison loses validity.
Other differences in the accounting method among firms in the same industry can cause difficulty in comparing debt to asset ratios. Firms may account differently for things like inventory or depreciation.
As we have seen, debt to asset ratios can be a useful measure of the financial health of a company. By analyzing the trend in the ratio and comparing the ratio to peers in the industry we can have a better idea of just how well the company is performing.
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