Debt to Assets Ratio

What is the Debt to Assets Ratio?

The Debt to Assets Ratio is a leverage ratioLeverage RatiosA leverage ratio indicates the level of debt incurred by a business entity against several other accounts in its balance sheet, income statement, or cash flow statement.  Leverage ratios include debt/equity, debt/capital, debt/assets, debt/EBITDA, and interest coverage. This guide has exmaples and Excel template that helps quantify the degree to which a company’s operations are funded by debt. In many cases, a high leverage ratio is also indicative of a higher degree of financial risk. It is because a company that is heavily leveraged faces a higher chance of defaulting on its loans as it is legally obligated to make periodic debt payments regardless of its sales numbers. During slow sales cycles or difficult economic times, a highly levered company will still need to make debt payments, which may result in a loss of solvencyInsolvencyInsolvency refers to the situation in which a firm or individual is unable to meet financial obligations to creditors as debts become due. Before beginning legal insolvency proceedings, the firm or individual may get involved in making an informal arrangement with their creditors as cash reserves dwindle.

The debt to assets ratio can also be thought of as the amount of a company’s assets that have been financed by debt. It will provide insights on past decisions made by management regarding the sources of capital they selected to pursue certain projects. By extension, we can also consider the debt to assets ratio as being an indirect way of measuring management’s usage of the capital structureCapital StructureCapital Structure refers to the amount of debt and/or equity employed by a firm to fund its operations and finance its assets.  The structure is typically expressed as a debt-to-equity or debt-to-capital ratio. Debt and equity capital are used to fund a business’ operations, capital expenditures, acquisitions, to fund NPV-positive projects.

How can we calculate the Debt to Assets Ratio?

The Debt to Assets Ratio can be calculated using the following formula:

Where:

Total Debt = Short Term Debt  + Long Term Debt

Total Assets = The sum of the value of all the company’s assets found on a company’s balance sheetBalance SheetThe balance sheet is one of the three fundamental financial statements. These statements are key to both financial modeling and accounting. The balance sheet displays the company’s total assets, and how these assets are financed, through either debt or equity. Assets = Liabilities + Equity

Debt to Assets Ratio Example

Max’s Coffee wants to calculate its debt to assets ratio in order to keep tabs on the company’s leverage. Below is the company’s balance sheet for the past few years:

The red boxes highlight the important information that we will need to calculate debt to assets, namely, short-term debt, long-term debt, and total assets. Using the formula provided above, we arrive at the following figures:

In the example above, we can see that Max’s Coffee consistently posted a debt to assets ratio of over 100%. It shows us that Max’s has more debt that it needs to repay than it has assets that can be liquidated in the case of bankruptcy. It would typically be an indicator of poor financial health as Max’s has a very high degree of leverage, and due to the likely very high periodic debt payments, Max’s is at a fairly high risk of defaulting on its debt. Nonetheless, if the business is able to generate strong and steady cash flows in each period, this position may be sustainable.

However, to better understand the financial health of the business, the debt to assets ratio should be computed and compared for a number of companies that operate in the same industry. If some other firms operating in this industry see a debt to asset ratio of over 200%, we can conclude that Max’s is doing a relatively good job of managing its degree of financial leverage. In turn, creditors may be more likely to lend more money to Max’s if the company represents a fairly safe investment within the coffee industry.

Additional Resources

Thank you for reading this article! CFI offers the Financial Modeling & Valuation Analyst (FMVA)™FMVA™ CertificationThe Financial Modeling & Valueation Analyst (FMVA)™ accreditation is a global standard for financial analysts that covers finance, accounting, financial modeling, valuation, budgeting, forecasting, presentations, and strategy.  certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following resources:

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