What is Debt to Asset Ratio – Simplest Explanation + Example]

The debt to Asset Ratio is one of the important factors that helps determine the business’s financial healthhelps determine the business’s financial health. In this post, we will be discussing a few points that will help us understand the debt to assets ratio and if it is the right choice. We will also be discussing a lot of topics around Debt to asset ratio that will help us understand if debt to asset is a good choice against equity.

Let us first understand the debt to asset ratio and then gradually discuss the topics around them. Are you with me? If there are any doubts, feel free to drop them in the comment section.

What is Debt to Asset Ratio – The Definition

The debt to asset ratio is used to determine a company’s leverage in accordance with the total amount of debt relative to assets owned by the company. For the same purpose, the Debt to asset ratio is also called the total debt to total asset ratio.

You must be wondering why total debt to total assets; this is because the ratio calculates the company’s total debt and not only the loans and bonds.

Let me make it easier for you. When you are making a loan, in the first step, you will analyze if the company can repay or make the returns. For which, you would conduct a background check, go through all the loans that the company has already taken, and at the end, conclude if the company will be able to repay with profits or returns in your favor. This is why we need to consider the total debt to total asset ratio before lending any money.

The debt to asset ratio is also considered for calculating a company’s financial situation compared to other companies. This way, investors know if it is a good choice to invest in a company and trust that they will repay the loan with profits. Eventually, if this ratio yields out negative information about the company, there are high chances that investors will not likely invest any money.

If you are in debt, the first thing you need to do is calculate the score and then work in order. This way, you will improve the ratio and bring a more positive face of the company to the investors. You can use CuraDebt to get a free consultation on Debt or improve your credit score to arrange fluid from the bank. But the best that you can do is get your free consultation from CuraDebt and analyze the situation. Only then will you be able to take proper action and improve the metrics.

Understanding Short-Term and Long-Term Debts

As discussed in the earlier section, we consider the total debts to total assets for calculating the debt to asset ratio. But what do you mean by total debts? The combination of short-term debt and long-term debt is considered as the total debt. Before proceeding ahead to the debt to asset ratio formula, let us quickly understand what you mean by short-term debt and long-term debt.

Short term debt:

Short-term debt, also called current liabilities, are debts that are expected to be cleared within one year. A few classic examples of Short-term debt are bank loans, lease payments, income taxes payable, dividends payable, and more.

Long term debt:

Long-term debt is one of the greater advantages of a financial model. Long-term debt is expected to be cleared by 12-months or longer and not considered as current liabilities on the sheets. But when calculating the debt to asset ratio, it is important to consider this aspect; though it is a long-term liability, it is still a liability.

The formula for Debt to Asset Ratio

We discussed what you mean by debt to asset ratio, short-term and long-term debts in earlier sections. Let me now show you how the debt to asset ratio is calculated.

Formula to calculate Debt to Asset Ratio –

Debt to Asset Ratio = Total Debt (Short Term+Long Term) ÷ Total Assets

If the above formula’s ratio crosses the value of 1 point, it signifies the company has more liabilities than assets. Moreover, it also hints there is a chance for the company to hit the defaulters list. This is because there is too much to pay to others that they are not likely to return your investment. This is why the debt to asset ratio is considered one of the important metrics. Would you have calculated this ratio if you had been to be an investor? What are your thoughts? Feel free to drop them in the comment section below.

Suppose the ratio or the percentage of the debt-to-asset ratio for a company ABC is 30%. This means 70% of the assets are bought using equity, and the company is still financially stable and can be invested in. On the other hand, if the debt-to-asset ratio for the ABC company is above 50% or is generally more than, it means that the company has more liabilities than assets. So, it would not be the right choice to invest in such a company.

In our practical example, Let us consider the data of ABC company as follows (in millions) –

In this case, the debt to asset ratio will be –

Debt to Asset Ratio = (700 ÷ 2500) x 100 = 28%

We multiplied the whole value by 100 to get a percentage, and it becomes easy to conclude. Now, here 28% signifies that 72% of the assets are bought using equity, and the ABC company is among one of the good companies to invest in.

Impact of Debt to Asset Ratio

The total debt to the total asset is one of the important metrics for a lender or an investor. If you are new to investing, let me tell you how impactful these values are and their significance. When you invest in a company, the leverage ratio or the total debt to total asset ratio helps calculate its growth. If the company has a score above 40 percent, it will likely not repay the loans or any profits. Besides, it will be tough to retrieve money as the company may be in total debt.

To Know the money that the company owns to other investors or creditors. You must know how much a company owes to other creditors before investing or crediting in it. If the company has more debts in lump-sum amounts, then the best option is to skip it. This is because they will likely not be able to recover your money. If the score is less and below 1, investors have a good space as the assets are more than liabilities. This indicates the company is in good fortune, and most of its assets are bought with equity than liabilities. Such companies also tend to return the money as quickly as possible with profits or returns.

The debt-to-asset ratio of the current fiscal year or the past year won’t help you in making a decision. To get the right values, you need to compare this metric with the previous 10-15 years of data and then come to a final judgement.

Limitations of Debt-to-Asset Ratio

There are a few limitations to the Debt-to-Asset ratio though it turns out to be a helpful metric for investors.

• Businesses whose data is being evaluated need to make sure the numbers being used are right. If there is confusion in numerator and denominator as the data is huge, it will lead to wrong conclusions.
  
• Different industries have different ways or accounting practices. Some consider long-term debt in the numerator to the total assets. At the same time, other businesses consider total debt in the numerator. This gives inaccuracies, and the ratio calculated will be wrong.
  
• Accounting practices also make significant differences when industries use different methods. Some may use depreciation, while others are using accounting methods. This creates inconsistencies, and the data evaluated will do injustice to the company or result in a loss for the investors.
  
• The debt to Asset ratio may be a limitation as sometimes, there is a need to look beyond it. Sometimes, investors might want to invest based on the company’s face value or brand value and the good looks, although they might be having huge debts. They say, sometimes trust is more than numbers.
  
• Though the debt-to-asset ratio is a good way to measure its financial health, it does not explain the asset’s quality and limits itself only to the numbers.
  
• A single evaluation will never be enough. In this case, there is a need for regular evaluations to check if the company’s financial health is improving or contracting.

Frequently Asked Questions

Final Words

A Debt to asset ratio is a helpful metric for investors and creditors. It helps them by evaluating a company’s financial health and making a decision if investing in a particular company can yield them returns along with profits. If you have unresolved debts, I highly suggest you take a 1-minute free debt consultation on CuraDebt. One of the oldest companies known for resolving millions of debts, you will never regret giving it a chance.