Table of Contents
Total Debt to Total Assets Ratio
This ratio is a metric to assess what percentage of assets are financed by borrowed funds. It is one of the leverage ratios utilized by lenders, creditors, investors, financial analysts etc. It evaluates the position of the company on the scale where the benefit of financial leverage is on one side and risk of bankruptcy on the other side.
Formula for Debt to Total Assets Ratio
Total Debt to Total Asset to Ratio = (Short Term Debts + Long Term Debts) / Total Assets
How to Calculate using Calculator
This calculator helps the user an easy and correct calculation of the ratio by inputting the following components.
- Long-Term Debt: It should include all the long-term debts of the company.
- Short-Term Debt: It should include all the short-term debts of the company.
- Total Assets: Total assets means all the assets whether it is current, fixed, tangible, or intangible. In short, it constitutes the complete asset side of a balance sheet.
Note: Shareholder’s equity is not part of this anyway
Say a Company A has total assets of $2,000,000 on its Asset’ side of the Balance Sheet. It has $700,000 generated out of Equity Capital and Reserves and the remaining 1,300,000 out of debts of the company. So,
Total Debt to Total Assets Ratio = Total Debts / Total Assets
= 13,00,000 / 20,00,000
= 0.65 ~ 65%
The ratio above shows that the debts finance a major portion i.e. 65% of the total assets.
Interpretation of Debt to Total Assets Ratio
This is a highly useful ratio for investors, creditors, financial analysts, company management etc. There can be two angles of looking at this ratio – Financial Leverage and Bankruptcy Risk.
We all know that infusion of debt capital by trading on equity will improve the equity shareholder’s return on investment. This theory is subject to the condition that the cost of debt is reasonably lower than the return that the company generates. Why should it be reasonably lower? Economic and business cycles are a reality. These may badly impact the return generated by the company. If there is a cushion, the benefit of leverage may sustain. On the contrary, if the cost of debt overruns the business returns, the business will start diluting the value of the shareholders.
If the financial leverage is too high like 65% in our example above, the risk perception of the investors, lenders will increase. This has various drawbacks like raising additional funds becomes very difficult. The higher fixed obligation in terms of higher interest costs approaches bankruptcy very fast even when there is a temporary liquidity crunch in the company.
At this juncture, the open question here is ‘What are the right levels of this ratio?’. As we have already mentioned that the benefit of financial leverage and bankruptcy risk are the opposite components on the same scale. Ideally, a balance between the two factors should be established. Industry norms can also guide to a great extent as the norms of this ratio may differ from industry to industry.