Debt to Assets Ratio
Measuring a company's leverage and long-term solvency
What is the Debt to Assets Ratio?
The Debt to Assets Ratio is a leverage ratio 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 solvency 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 structure 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 sheet
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
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