The debt to asset ratio is a crucial financial ratio to infer the importance of leverage in a company. The debt to asset ratio represents the financial health of a company and the debt to asset ratio established a relationship between total liabilities and its total assets.
The debt to asset ratio brings it manageable to compare the degrees of leverage in various companies.
It is an indicator of financial leverage and higher financial leverage companies may impose themselves at high risk of solvency or bankruptcy.
What is Debt To Asset Ratio?
The debt to asset ratio is also known as the total debt to total asset ratio that shows the proportion of assets being held by a company that is funded by debt. It is an indicator of the use of external funds in the company.
Investors also use it to confirm the company is solvent and the company can fulfil existing and forthcoming debts and can earn revenue on their investment.
A high debt to asset ratio may indicate a higher financial risk that means the weak solvency of the company. The debt to asset assists to understand the assets financing pattern of the company.
Debt To Assets Ratio Formula
The debt to assets ratio formula is calculated by dividing total liabilities by total assets. The reason for the calculated debt to asset ratio is that the total debt is a percentage of the total amount of assets.
Debt to asset ratio = (Total liabilities / Total assets)
Where total debts include long term liabilities and short term liabilities as listed in the balance sheet.
Likewise, the sum of all assets listed on the balance sheet of a company. The total assets include current assets, non-current assets and other assets as well. There is more than one variety of this formula depending on who is analyzing it.
Few analysts eliminate current liabilities and current assets as part of the working capital of the business and they considered simply non-current assets and other assets along with just long term liabilities.
Debt to Asset Ratio Example
It is an ABC company. Here is some information about ABC company,
The balance sheet of the ABC company as on 31.03.2019
| Particular | Amount (Rs.) |
|---|---|
| Non-current assets | |
| Fixed assets | 425,000 |
| Long term investments | 390,000 |
| Total non-current assets | 815,000 |
| Current assets | |
| Cash in hand | 20,000 |
| Bills receivable | 50,000 |
| Inventory | 250,000 |
| Prepaid expenses | 100,000 |
| Short term loans | 200,000 |
| Total current assets | 620,000 |
| Total assets | 14,35,000 |
| Equity | |
| Share capital | 600,000 |
| Reserve | 330,000 |
| Total equity | 930,000 |
| Non-current liabilities | |
| Debentures | 200,000 |
| Long-term loans | 150,000 |
| Total non-current liabilities | 350,000 |
| Current liabilities | |
| Bills payable | 50,000 |
| Overdraft | 100,000 |
| Short-term loans | 5,000 |
| Total current liabilities | 155,000 |
| Total equity and liabilities | 14,35,000 |
Using the number, we can calculate the debt to asset ratio:
Debt to asset ratio = (155000 / 1435000)
Debt to asset ratio = 0.108 or 10.8%
The debt to asset ratio of the ABC company is 10.8% which means that all the assets of the company are funded by debt. ABC company is in a good position.
Debt to Assets Ratio Interpretation
The debt to asset ratio is a crucial tool that measures how much of the total assets are financed through debt funds.
A highly leveraged company may undergo financial troubles such as a recession or an unexpected rise in interest rates.
The debt to asset ratio is a significant metric for the investors. The ideal debt to asset ratio is less than 0.5 for a company.
If most of the assets of the company are in the form of obligations which infers that the company may struggle to pay off its obligations at the right time.
A high debt to asset ratio not only indicates a higher risk for the equity shareholders of the company but also implies that sustainable profits of the company are lost in paying interest.
A low debt to asset ratio is better for the shareholders as well as for existing debt holders. In tougher times, companies with lower debt ratios survive better.
Investors or analysts usually prefer a lower debt to asset ratio. A smart investor should track and follow the trend of the last five years debt ratio, which informs us of the last five years performance of a company and good idea to compare companies within the same sector. The debt ratio favoured 0.5 is favoured by the investors.
What is a good debt to asset ratio?
A good debt to asset ratio may differ relying on the certain norms of a business and its industry.
As a rule of thumb, investors and creditors always glance for a company that has less than 0.5 of debt to asset ratio.
But to determine whether the ratio is high or less, they should consider what industry the company is in.
High Capital intensive companies have higher debt ratio because they purchase fixed assets such companies.
Less capital intensive companies have lower debt ratios. Such IT sector etc.
1. Higher debt ratio acceptable when companies have stable cash flows. Eg. Power companies, banks etc. In that case, the debt ratio has to be less than 0.75.
2. A high debt ratio is not acceptable when companies have uneven cash flows. Eg. Construction etc.
How to improve debt to asset ratio?
If a company has a higher debt to asset ratio, it needs to reduce the same. The company should reduce the debt proportion to lower the ratio. However, here are some strategies to improve the debt to asset ratio following:
New or additional stock issue:
The company can issue new or additional shares to raise its cash flow. This cash can be used for repaying current debts and reduce the company's debt limitation. The debt reduction would, in turn, lower the debt to assets ratio.
Lease assets:
A company can sell its assets and then lease its properties back. This will induce cash flow which may be used to pay off debts to some extent.
Implementation of debt/equity swap:
A company may make a debt holder an equity shareholder in the company by executing a debt/equity swap.
This will remove the debt owed to him and in turn, reduce the obligation of the company and will also enhance the ratio. Convertible debentures can be issued as essential.
Increase the sales:
The company can depend heavily on sales and revenue growth but without any increase in the operating expenses.
The increase in sales can be used to diminish the debt proportion and improve the debt to total assets ratio.
Limitations of the debt to asset ratio
The debt to asset ratio has also particular limitations and investors should be aware of that.
Here are the limitations of the debt to asset ratio following:
1. One drawback of the debt to assets ratio is that it does not deliver any evidence of asset quality since it lumps all tangible and intangible assets together.
2. Possibility of manipulation through accounting principles and treatment.
It uses financial data that may be manipulated to further improve the relevant financial measurement which financial information should not be like if it is properly recorded, measured and identified.
