The debt to asset ratio falls under the solvency category of the ratios. Solvency ratios evaluate the entity’s ability to survive over a longer period of time. This ratio calculates what portion of assets the business owner(s) financed with the help of outside debt rather than capital.
The debt to asset ratio can be viewed as a risk analysis ratio. It identifies the financing risk associated with a company’s capital structure. You are looking at this from a financing standpoint because you do not want your business to be illiquid, meaning that you do not have enough cash to be able to pay your liabilities. Thus, the management would use this debt to asset ratio to help it understand the financial risk of an organization.
The debt to assets ratio is relatively easy to calculate. All you need to do is take total liabilities and divide it by your entity’s total assets. Let’s take the accounting financial report of the following company and try to calculate its debt to asset ratio.
Our first step is to find the numbers we need for the calculation. From the example financial report, we can see that the total assets are equal to $101,000 and total liabilities make up $16,000. To calculate our ratio, we will simply $16,000 by $101,000. This will give us .1584 or 15.84%.
What does this leverage ratio tell its user? This financial ratio tells us the percentage of assets financed by debt as opposed to equity. Basically, we can find out if a company’s assets are more financed by debt or equity. Debt would mean that if the business does not pay those loans and debts off, the loan holder may be able to repossess those assets, which is not always a great thing at the end of the day, especially if the company is at a point where it has a hard time paying off those liabilities.
When the company pays with equity, then it owns it outright. If there is a downturn in the market and the company does not have enough cash to pay for the liabilities, it would still keep its assets because it does not have any liabilities on them. However, this means that the business is tying up its own money in those assets. With the debt, a downside is that a company has to pay interest. Debt also helps to finance a purchase of incredibly expensive assets that a business might still need.
The higher this debt ratio, the riskier the company is from a debt capital structure standpoint. That is, if the company pays for assets mostly with money it loaned, the ratio will get close to 100%. On the other hand, if the debt covered only a small portion of the assets owned, the ratio will be closer to 0%. The ratio that is closer to 100% is riskier because there is always a chance that the institution that gave the loan can call it back.
When interpreting the results, you also need to compare them with past results and industry data and see if there is a significant difference. Why? It might turn out that such a high ratio is standard for such companies. The business might be in an industry where that is the way that companies finance their assets. One such example is the real estate industry.
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Author: Charles Lutwidge