Debt to total asset ratio is the ratio indicating the percentage of total assets of the company financed from debt. It is a broad financial parameter used to measures what part of assets are served by liabilities (debt) signifying financial risk. It is one of the solvency ratios and helps in measuring how far the company is capable of meeting its long-term financial obligations.
Formula of Debt to Total Asset Ratio
The formula can be expressed as mentioned below:
Debt to Total Asset Ratio = (Total Debt OR Total Liability) / Total Assets
Total Debt = Long-Term Liabilities + Current Liabilities (i.e. Long-Term Debt and Short-Term Debt but does not include capital of shareholders)
Total Assets = All Assets (Current, Fixed, Tangible, Intangible)
Analysis and Interpretation of Debt to Total Asset Ratio
Just like other financial ratios, this ratio can be correctly interpreted when compared to its industry average or value of this ratio with competitor companies. If this ratio is >0.5, it is considered that the company is highly leveraged i.e. more than 50% assets are from borrowings either short term or long term.
Lower debt to total asset ratio is considered better as a sign of financial stability of the company. This is because, if the value of debt to total asset ratio is low, it suggests that the company has borrowed fewer funds as compared to total assets that it owns. On the other hand, if the company has high debt to total asset ratio, it suggests that a company has borrowed huge funds and therefore higher financial risk.
A high debt to total asset ratio does not go too well with the investors too. It suggests that a high portion of the company’s assets are claimed by the creditors. Also, if a company has a high debt, it will end up paying a huge chunk of its operating profits on interest, which signifies higher risk associated with the company’s operations.
If we look from a longer and futuristic perspective, a high debt to total asset ratio also suggests that the company is risky to invest in because to the company would not be able to secure loans for its future projects due to already higher debt to asset ratio resulting in lower borrowing capacity.
Calculate Debt to Total Asset Ratio with Example
Consider following figures.
Current Liabilities = USD 50,000
Non-Current Liabilities = USD 250,000
Shareholder’s Equity = USD 100,000
Thus, we have,
Debt to Total Asset Ratio = 300000 / 400000 = 0.75
Thus, it can be implied that about 75% of company’s assets are met by debt. If a majority of these 75% lenders starts claiming their money, the company may face cash flow mismatch problem which may lead to bankruptcy.
Using Debt to Total Asset Ratio
It is important to compare the debt to total asset ratio of various companies within the same sector. The nature of some industries may require a company to borrow a lot of money. E.g. Infrastructure sector. Thus, comparing the debt to total asset ratio of companies in different sectors might give you a misleading picture.
One can also use debt to total asset ratio to gauge the financials of a company over a period of time. If the value of this ratio has increased significantly over a period of time, it may ring warning bells for the company, and thereby for its investors.