Measuring the proportion of a company’s assets that are funded by debt
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The debt to asset ratio is a financial metric used to help understand the degree to which a company’s operations are funded by debt. It is one of many leverage ratios that may be used to understand a company’s capital structure.
The debt to asset ratio is calculated by using a company’s funded debt, sometimes called interest bearing liabilities. This refers to actual credit provided by direct lenders for which there are interest obligations (like bonds, term loans from a commercial bank, or subordinated debt); the ratio does not include total liabilities (like accounts payable, etc.).
The total funded debt — both current and long term portions — are divided by the company’s total assets in order to arrive at the ratio. This ratio is sometimes expressed as a percentage (so multiplied by 100).
Key Highlights
Debt to assets is one of many leverage ratios that are used to understand a company’s capital structure.
The ratio represents the proportion of the company’s assets that are financed by interest bearing liabilities (often called “funded debt.”)
The higher the ratio, the greater the proportion of debt funding and the greater the risk of potential solvency issues for the business.
There is no absolute “good” or “ideal” ratio; it depends on many factors, including the industry and management preference around debt funding.
Understanding Leverage
The fundamental accounting equation is Assets = Liabilities + Equity. And while not all liabilities are funded debt, the equation does imply that all assets are funded either by debt or by equity.
A company with a higher proportion of debt as a funding source is said to have high leverage.
A company with a lower proportion of debt as a funding source is said to have low leverage.
Calculating the Debt to Asset Ratio
Looking at the following balance sheet, we can see that this company has employed funded debt in its capital structure.
In order to calculate the debt to asset ratio, we would add all funded debt together in the numerator: (18,061 + 66,166 + 27,569), then divide it by the total assets of 193,122.
In this case, that yields a debt to asset ratio of 0.5789 (or expressed as a percentage: 57.9%).
Debt to Asset Ratio Explained
Of all the leverage ratios used by the analyst community to understand the financial position of a company, debt to assets tends to be one of the less common ones.
It represents the proportion (or the percentage of) assets that are financed by interest bearing liabilities, as opposed to being funded by suppliers or shareholders. As a result it’s slightly more popular with lenders, who are less likely to extend additional credit to a borrower with a very high debt to asset ratio.
In the above-noted example, 57.9% of the company’s assets are financed by funded debt. As with any ratio, however, it can’t be taken in isolation. Analysts will want to compare figures period over period (to assess the ratio over time), or against industry peers and/or a benchmark (to measure its relative performance).
A valid critique of this ratio is that the proportion of assets financed by non-financial liabilities (accounts payable in the above example, but also things like taxes or wages payable) are not considered. In other words, the ratio does not capture the company’s entire set of cash “obligations” that are owed to external stakeholders – it only captures funded debt.
Important Considerations about the Debt to Asset Ratio
There is no perfect score or ideal debt to asset ratio. As with all financial metrics, a “good ratio” is dependent upon many factors, including the nature of the industry, the company’s lifecycle stage, and management preference (among others).
Some important considerations include the following:
A ratio approaching 1 (or 100%) is an extraordinarily high proportion of debt financing. This would be unsustainable over long periods of time as the firm would likely face solvency issues and risk triggering an event of default.
A debt to asset ratio that’s too low can also be problematic. While unlikely to cause solvency issues, it could indicate poor capital structure decisions by management, resulting in a suboptimal return on equity for the firm’s shareholders.
The ratio is only useful in comparing businesses within the same industry, as the capital structures of different industries are specific to those industries. For example, for industries where there is a large proportion of tangible assets (like A/R, inventory, equipment, and commercial real estate), the book value of intangible assets may be minimal. Intuitively, such companies cannot be compared to other companies in industries that have a comparable funded debt to asset ratio, but where the assets are mostly held in intangible forms (goodwill, trademarks, patents, etc.).
One European Central Bank study suggests that for micro-, small-, and medium-sized firms, a ratio above 0.80-0.85 (80-85%) negatively affects capital investments in the levered firms[1].
The debt ratio, or total debt-to-total assets, is calculated by dividing a company's total debt by its total assets. It is also called the debt-to-assets ratio. It is a leverage ratio
leverage ratio
A leverage ratio is any one of several financial measurements that assesses the ability of a company to meet its financial obligations. A leverage ratio may also be used to measure a company's mix of operating expenses to get an idea of how changes in output will affect operating income.
Generally speaking, a debt-to-equity or debt-to-assets ratio below 1.0 would be seen as relatively safe, whereas ratios of 2.0 or higher would be considered risky. Some industries, such as banking, are known for having much higher debt-to-equity ratios than others.
Signal: Under .5 or 50% is better; over 1.0 or 100% would indicate that liabilities exceed assets, which is not desirable; upward trend may be cause for concern. Calculation: Total liabilities may also be divided by total income or total capital for a different emphasis.
The 1.5 multiple in the ratio indicates a very high amount of leverage, so ABC has placed itself in a risky position where it must repay the debt by utilizing a small asset base.
In general, many investors look for a company to have a debt ratio between 0.3 and 0.6. From a pure risk perspective, debt ratios of 0.4 or lower are considered better, while a debt ratio of 0.6 or higher makes it more difficult to borrow money.
There's no ideal figure, but a ratio of less than 0.5 is generally preferred. You can evaluate the debt to asset ratio of a company over different periods, comparing them to competitors in their industry.
If the ratio is below 1, the company has more assets than debt. Broadly speaking, ratios of 60% (0.6) or more are considered high, while ratios of 40% (0.4) or less are considered low.
It suggests a smaller proportion of an entity's assets are financed through debt, which can be seen as a positive sign of financial stability and a lower risk of default. High debt ratio: If the result is a big number (like 0.7 or 70%), it means the company owes a lot compared to what it owns.This could be risky.
DTI from 43% to 50%: A DTI ratio in this range often signals to lenders that you have a lot of debt and may struggle to repay a mortgage. DTI over 50%: A DTI ratio of 50% or higher indicates a high level of debt and signals that the borrower is probably not financially ready to repay a mortgage.
In general, though, a higher Debt to Asset Ratio indicates higher leverage, which, while offering the potential for greater returns, also carries a higher risk of financial distress or even bankruptcy.
Do I need to worry about my debt ratio? If your debt ratio does not exceed 30%, the banks will find it excellent. Your ratio shows that if you manage your daily expenses well, you should be able to pay off your debts without worry or penalty. A debt ratio between 30% and 36% is also considered good.
What is a good long-term debt ratio? A long-term debt ratio of 0.5 or less is considered a good definition to indicate the safety and security of a business.
In general, a ratio around 0.3 to 0.6 is where many investors will feel comfortable, though a company's specific situation may yield different results.
Generally, a good debt ratio is around 1 to 1.5. However, the ideal debt ratio will vary depending on the industry, as some industries use more debt financing than others. Capital-intensive industries like the financial and manufacturing industries often have higher ratios that can be greater than 2.
To bring your Debt to Assets Ratio into range, assets have to increase or debt has to decrease. Increasing assets will often require a loan (more debt), new investors, or more importantly, retained earnings. New investors come with strings attached, but can often provide immediate improvement in Debt to Assets.
If the ratio is over 1, a company has more debt than assets. If the ratio is below 1, the company has more assets than debt. Broadly speaking, ratios of 60% (0.6) or more are considered high, while ratios of 40% (0.4) or less are considered low.
35% or less is generally viewed as favorable, and your debt is manageable. You likely have money remaining after paying monthly bills. 36% to 49% means your DTI ratio is adequate, but you have room for improvement. Lenders might ask for other eligibility requirements.
A good debt ratio is usually below 0.50 or 50% This means the company's assets are mainly funded by equity instead of debt. However you should research the industry average to get a full picture. What is debt ratio analysis? Debt ratio analysis is used to review whether or not a company is solvent long-term.
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