Debt to Total Asset Ratio is a ratio that determines the extent of a company’s leverage. This ratio makes it easy to compare the leverage levels in different companies. The debt to Total Asset Ratio is a very important ratio in ratio analysis. The article clarifies how we can analyze this ratio and interpret it to use it for making important financial decisions. Let us see how to analyze and improve the debt-to-total asset ratio.
Definition of Debt to Total Asset Ratio
The debt to Total Asset Ratio is a solvency ratio that evaluates a company’s total liabilities as a percentage of its total assets. It is calculated by dividing the total debt or liabilities by the total assets. This ratio aims to measure the ability of a company to pay off its debt with its assets. To put it simply, it determines how many assets should be sold to pay off the company’s total debt. This is also termed as measuring the financial leverage of the company.
How to Interpret Debt to Total Asset Ratio?
There is a general practice of showing the debt to total asset ratio in decimal format ranging from 0.00 to 1.00. A ratio of 0.5 indicates that half of the company’s total assets are financed by liabilities. In other words, the debt is only 50% of the total assets.
A lower value of the ratio is better than a higher number. A lower ratio signals a stable company with a lower proportion of debt. A higher ratio means that the company’s creditors can claim a higher percentage of the assets. This translates into higher operational risk as financing new projects will get difficult. Companies with higher debt-to-total asset ratios should look at equity financing instead.
Why Is It Necessary To Improve Debt to Total Asset Ratio?
A higher debt-to-total asset ratio is very unfavorable for a company.
- Firstly, it indicates that a higher percentage of assets are financed through debt. This means that the creditors have more claims on the company’s assets.
- Secondly, a higher ratio increases the difficulty of getting loans for new projects as the lenders will see the company as a risky asset.
- Thirdly, a higher debt-to-total asset ratio also increases the insolvency risk. If the company is liquidated, it might not be able to pay off all the liabilities with its assets.
Therefore, the company must work towards improving the debt-to-total asset ratio.
How to Improve Debt to Total Asset Ratio?
If a company has a higher debt-to-total asset ratio, it needs to lower it. The company should reduce the debt proportion to lower the ratio. However, it can also follow several other options to improve the debt-to-total asset ratio:
Additional/ New Stock Issue
The company can issue new or additional shares to increase its cash flow. This cash can be used to repay the existing liabilities and, in turn, reduce the debt burden. The debt reduction will lower the debt-to-total asset ratio.
Debt / Equity Swap
By implementing a debt/equity swap, a company can make a debt holder an equity shareholder in the company. This will cancel the debt owed to him and, in turn, reduce the company’s debt and improve the ratio. If planned, convertible debentures can be issued.
The company can sell its assets and then lease them back. This will induce a cash flow that can be used to pay off some debts.
Increase the Sales
The company can focus heavily on increasing sales but without any increase in overhead expenses. The increase in sales can be used to reduce the debt and improve the debt-to-total asset ratio.
FULL RATIO ANALYSIS (32 RATIOS)
We have covered the complete ratio analysis – its significance, application, importance, and limitations, and all 32 RATIOS of ratio analysis that are structured and categorized into 6 important heads.
The debt to Total Asset Ratio is an important solvency ratio. The company needs to monitor this ratio regularly, as creditors will always keep an eye on this ratio. The creditors are worried about getting their money back, and a higher debt-to-total assets ratio will translate into no loans for new projects. Thus, the company should always aim to keep the ratio in an acceptable range.