What is the Debt to Asset Ratio?
Definition: Debt to asset ratio is a financial leverage ratio that shows the total assets of a company financed through creditors relative to those funded by investors. Analysts use this measure to compare the leverage of one company to another provided they operate within a similar sector. Leverage is considered as a growth approach which means a company can borrow so that it can enhance its productivity. This information is very vital in that it can show the financial position of the company.
In essence, the ratio will show the proportion of the company’s assets financed through borrowing relative to the assets that are funded through resources from investors. This metric is important in that it demonstrates the amount of leverage in the company through a comparison of the assets owned by shareholders through equity and those funded by debt from creditors.
Creditors and lenders employ asset to debt ratio to assess the amount of debt the company owes currently and its ability to meet debt obligations. On the other hand, investors will employ the measure to evaluate if the company is capable of repaying its debt without defaulting. From this, they are able to determine if the company is profitable before they can invest in it. In simpler terms, it means that investors will gauge the investment value in the company usually in equity to see if there is the potential of growing or declining in the long run.
Debt to Asset Ratio Formula
To calculate the debt asset ratio formula you need to have total debt and the company’s total assets. You can compute total debt as a ratio of assets.
Total debt includes both long-term and short-term debts. Usually, debts expected to be settled within a year are referred to as short-term debts while those that could go past one year are referred to as long term debts.
To get total assets you have to add all the company’s total equity and liabilities and this can be picked from the balance sheet. Assets include intangible assets such as patents, copyrights, and goodwill that have are not in physical form but hold value in theory. Tangible assets are all those that have an exchange value and are in physical form.
Debt to Asset Ratio Example Analysis
Creditors, investors, and analysts employ this metric to determine a company’s risk. If a company has a high debt to asset ratio then it means a higher level of leverage which means the company is risky to loan or invest in considering it is more leveraged. Therefore the company will be required to use most of its profits as interest and principal payments.
A company holding most of its assets in debts will find it difficult to pay its debt in due time compared to one whose assets are funded by investors. Such a company could find itself in a difficult situation if interest rates increase due to a financial crunch.
If a company’s debt to assets ratio is one then that implies that its assets equal to liabilities. Conventionally creditors and investors want a company whose debt asset ratio is less than 0.5. However, it is important to note that to ascertain if the ratio is low or high one should consider which industry the firm is operating in. usually, pipeline companies will have a higher ratio relative to tech firms because pipeline companies tend to have steady cash flows. Therefore it is important when comparing debt asset ratio to consider companies operating in similar industries.
Debt to Asset Ratio Limitations
Like most financial measurement debt to asset ratio also has its limitations. One of the most apparent shortcomings is that it does not include intangible assets as part of total assets. Interestingly this might affect one’s evaluation of the company. Therefore to enhance the accuracy of the ratio it is important to calculate it at various times to track any change.