If, for instance, your company has a debt-to-asset ratio of 0.55, it means some form of debt has supplied 55% of every dollar of your company’s assets. If the debt has financed 55% of your firm’s operations, then equity has financed the remaining 45%. A high debt-to-assets ratio could mean that your company will have trouble borrowing more money, or that it may borrow money only at a higher interest rate than if the ratio were lower. Highly leveraged companies may be putting themselves at risk of insolvency or bankruptcy depending upon the type of company and industry. Some industries can use more debt financing than others.
How to Calculate the Debt-to-Asset Ratio
In order to calculate the business firm’s debt-to-asset ratio, you need to have access to the business firm’s balance sheet. Here is a hypothetical balance sheet for XYZ company: So with Company XYZ, we would look at $814 million in total liabilities divided by $2,000 in total assets:
Debt-to-Assets = 814 / 2000 = 40.7%
This tells you that 40.7% of your firm is financed by debt financing and 59.3% of your firm’s assets are financed by your investors or by equity financing.
Comparative Ratio Analysis
To find relevant meaning in the ratio result, compare it with other years of ratio data for your firm using trend analysis or time-series analysis. Trend analysis is looking at the data from the firm’s balance sheet for several time periods and determining if the debt-to-asset ratio is increasing, decreasing, or staying the same. The business owner or financial manager can gain a lot of insight into the firm’s financial leverage through trend analysis. The second comparative data analysis you should perform is industry analysis. In order to perform industry analysis, you look at the debt-to-asset ratio for other firms in your industry. If your debt-to-asset ratio is not similar, you try to determine why.
Why the Debt-to-Asset Ratio Is Important for Business
Companies with high debt-to-asset ratios may be at risk, especially if interest rates are increasing. Creditors prefer low debt-to-asset ratios because the lower the ratio, the more equity financing there is which serves as a cushion against creditors’ losses if the firm goes bankrupt. Creditors get concerned if the company carries a large percentage of debt. They may even call some of the debt the company owes them. Investors in the firm don’t necessarily agree with these conclusions. If the firm raises money through debt financing, the investors who hold the stock of the firm maintain their control without increasing their investment. Investors’ returns are magnified when the firm earns more on the investments it makes with borrowed money than it pays in interest. However, the investor’s risks are also magnified.
Limitations of the Debt-to-Asset Ratio
There are limitations when using the debt-to-assets ratio. The business owner or financial manager has to make sure that they are comparing apples to apples. In other words, if they are doing industry averages, they have to be sure that the other firm’s in the industry to which they are comparing their debt-to-asset ratios are using the same terms in the numerator and denominator of the equation. For example, in the numerator of the equation, all of the firms in the industry must use either total debt or long-term debt. You can’t have some firms using total debt and other firms using just long-term debt or your data will be corrupted and you will get no helpful data. Another issue is the use of different accounting practices by different businesses in an industry. If some of the firms use one inventory accounting method or one depreciation method and other firms use other methods, then any comparison will not be valid. Business managers and financial managers have to use good judgment and look beyond the numbers in order to get an accurate debt-to-asset ratio analysis.
