Debt to asset, also known as total debt to total asset, is a ratio that indicates how much leverage a company can use by comparing its total debts to its total assets. “Leverage” is a growth strategy. It means a company is using cash flow from loans as resources to improve their productivity. Simply put, debt to asset measures the company’s dependency on debt.
The debt to asset ratio is mostly used by creditors, lenders, and investors. Creditors use the ratio to evaluate how much debt a company currently has. It also assesses their the ability to fulfil the payments for those obligations. Meanwhile, investors use the ratio to see if a company can repay its debt before it’s due. They also use it to see if it would be profitable to invest in the company.
In other words, investors often try to assess if the value of investments to the company—usually in the form of stocks—will potentially go up or go down in the long run. Debt to asset is also sometimes referred to as the debt ratio since they have a very similar formula.
Debt to Asset Formula
$$Debt\:to \: Asset\: Ratio =\dfrac{Total\: Debt}{Total\: Assets}$$
For this formula, you need to know the company’s total amount of debt, short term and long term, as well as total assets. A debt is considered short term if it is expected to be repaid within one year. Anything beyond that is would be long-term.
For total assets, you can also get the number by summing the company’s equity and total liabilities. These are usually found on the company’s balance sheet. Assets comprise both tangible and intangible assets. Tangible assets are assets that usually have a physical form and determined exchange value. On the other hand, intangible assets are resources that only have a theorized value and no physical form such as goodwill, patents, and copyrights. However, these may not have a set value.
A higher debt to asset ratio means a higher degree of leverage. The results of the ratio directly correlate with the degree of risk the company is taking on. Among the company’s assets, if most of them are in the form of debts, it means that the company will most likely struggle to pay its debt off in time. This results from higher debts rather than equity, which is assets that a company truly owns.
The debt to asset ratio is often presented as decimal but can be presented as a percentage as well. Investors and creditors are generally looking for companies that have less than 0.5 of the debt to asset ratio. To get a more comprehensive result, you can also compare the ratio in multiple periods to check for stability.
Debt to Asset Example
Andy wants to buy stocks. He wants to know if a particular oil company is a good candidate for his investment. Andy uses the debt to asset ratio as one of his instruments to determine this. By looking at the company’s balance sheet from last year, he finds out that the company had $2,760,000 in total assets. In addition, Andy also discovers that the company had a total amount of short term debts of $198,000 and long term debts of $1,620,000. Can we calculate the company’s debt ratio based on this data?
Let’s break it down to identify the meaning and value of the different variables in this problem.
- Short-term debts: 198,000
- Long-term debts: 1,620,000
- Total debt: 198,000 + 1,620,000 = 1,818,000
- Total assets: 2,760,000
We can apply the values to our variables and calculate the debt to asset ratio:
$$Debt\:to \: Asset\: Ratio =\dfrac{1{,}818{,}000}{2{,}760{,}000} = 0.6587$$
In this case, the debt to asset ratio of the company would be 0.6587 or 65.87%.
From this result, we can see that the company is taking a risky approach to financing its operation by possibly biting off more debt than it can chew. You can tell this because the company has more debts than equity in its assets (more than 0.5 of debt to asset ratio). The company may survive a couple of years, but they could be in danger of failing by then. In this case, Andy may want to steer clear of the company.
Debt to Asset Analysis
Debt to asset is a crucial tool to assess how much leverage the company has. This translates to how possibly a company can company survive and thrive for years to come. A highly leveraged company may suffer during financial difficulties such as recession or interest rates sudden rise.
This formula is one of many leverage ratios often used by investors and creditors. These ratios have one major similarity. They assess the business’ ability to repay their debt. Companies often combine equity and debts to fund their operations. However, if creditors and investors don’t take any of these ratios into account, they wouldn’t know if a company can pay off its debts in time. They might be caught off guard if the company were suddenly approaching bankruptcy.
As a rule of thumb, investors and creditors often look for a company that has less than 0.5 of debt to asset ratio. However, to determine whether the ratio is high or low, they also need to consider what type of industry the company is categorized in. For example, pipeline companies usually have a higher debt to asset ratio than technology companies since pipeline companies have comparably more stable cash flows. Because of this, it’s a good idea to only compare companies within the same industry.
As with most measurements, the debt to asset ratio is not without limitations. The most obvious flaw is that intangible assets aren’t included in the total assets. This could affect the analysis you’ve completed for a company. For example, intellectual property usually won’t appear (or will be improperly presented) on the balance sheet since it has no defined value. To increase accuracy, you can evaluate the ratio at different times to follow its change.
Debt to Asset Conclusion
- The debt to asset ratio measures how much leverage a company uses to finance its assets using debts.
- The formula for requires two variables: total debt (short- + long-term debt) and total assets
- This ratio is often used by investors and creditors to determine if a company can pay off its debts on time and be profitable in the long run.
- 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 competitors in their industry.
Debt to Asset Calculator
You can use the debt to asset calculator below to quickly measure how much leverage a company uses to finance its assets using debts by entering the required numbers.