tang90246/iStock via Getty Images
What the Debt-to-Asset Ratio Is
The debt-to-asset ratio is a financial ratio used to determine the degree to which companies rely on leverage to finance their operations. Also referred to as a debt ratio, the debt-to-asset ratio considers all debt held by a company, including all loans and bond debt, and all assets, including intangible assets.
If the ratio, which shows debt as a percentage of assets, is greater than 1, it's an indication the company owes more debt than it has assets. That could mean the company presents a greater risk to investors or lenders, especially if the debt has a variable rate of interest and interest rates are rising. A lower ratio indicates a company relies less on debt and finances a more significant portion of its assets with equity. That may be an indication the company is more financially stable.
Key Takeaway: A high debt-to-asset ratio is an indication a company is highly leveraged and relies heavily on debt to finance its operations.
Debt-to-Asset Ratio Formula & Calculation
The formula for calculating the debt-to-asset ratio is straightforward:
Debt-to-Asset Ratio = Total Debt / Total Assets
All the information for calculating the debt-to-asset ratio can be found on a company's balance sheet. The Assets section lists all current and non-current assets. The Liability section lists all the company's liabilities and long-term debt and totals for both assets and liabilities are indicated. To calculate the ratio, divide Total Debt by Total Assets.
Consider the balance sheet below:
Balance Sheet | ||||||
Assets | ||||||
Cash | $267,971 | |||||
Accounts Receivable | 5,100 | |||||
Inventory | 7,805 | |||||
Property & Equipment | 45,500 | |||||
Total Assets | $326,376 | |||||
Liabilities | ||||||
Accounts Payable | $3,902 | |||||
Debt | 100,000 | |||||
Total Liabilities | $103,902 | |||||
Shareholder's Equity | ||||||
Equity Capital | $247,474 | |||||
Retained Earnings | 2,474 | |||||
Shareholder's Equity | $172,474 | |||||
Total Liabilities & Shareholders' Equity | $326,376 | |||||
The balance sheet shows $326,376 of total assets and $100,000 of total debt. The calculation of the debt to asset ratio is as follows:
Debt-to-Asset Ratio = $100,000 / $326,376 = 0.306395 = 31%
The debt-to-asset ratio indicates that the company is funding 31% of its assets with debt.
Understanding Debt-to-Asset Ratio
Essentially, the debt-to-asset ratio is a measure of a company's financial risk. Investors and lenders look to the debt-to-asset ratio to assess a company's risk of becoming insolvent. Companies with a high ratio are more leveraged, which increases the risk of default.
Lenders may be hesitant to lend to companies with an already high debt-to-asset ratio and, if they do, it would likely be at a higher rate of interest than they would charge for companies with a low debt-to-asset ratio. This stands to reason, since lending to a company with a high debt ratio suggests a greater risk of recovering the loan, should the company become insolvent.
Also, highly leveraged companies can become financially distressed when interest rates rise, making it increasingly difficult to generate positive returns on equity, invest in future growth, and maintain debt obligations.
A debt ratio greater than 1 means a company's debt exceeds its assets. This amount of leverage might boost potential earnings, but would also be considered an extremely leveraged position with a high risk of default. A ratio less than 1 means a company owns more assets than debt, giving it the capacity to meet its debt obligations by selling its assets if necessary and leaving room to take on more debt should a problem or an opportunity present itself. Companies with a low debt ratio are considered more financially stable and less risky for investors and lenders.
As with other financial ratios, the debt ratio should be considered within context. It can be evaluated over time to determine whether a company's overall risk is improving or worsening and it should be assessed in the context of the specific industry.
For example, companies in capital-intensive industries, such as utilities, airlines, and telecommunications, must make significant investments in infrastructure, supplies, and equipment to deliver their goods or services. For these companies, a high debt ratio may be necessary for growth.
Industries with lower debt-to-asset ratios, such as services and wholesalers, tend not to have a lot of assets to leverage. Companies in more volatile sectors such as technology also tend to operate with less debt and lower ratios.
Key Takeaway: High debt ratios by themselves may or may not represent a serious problem and should be considered relative to historic levels as well as in comparison to other companies in the same industry. In capital-intensive industries such as airlines, a high debt-to-asset ratio is considered the norm.
Debt-to-Asset Ratio Example
Here is a comparison of the debt-to-asset ratios of three companies:
Debt-to-Asset Ratio | |||||
Company | ST Debt | LT Debt | Assets | Debt/Asset | |
Company X | 100 | 300 | 900 | 44.4% | |
Company Y | 0 | 100 | 868 | 11.5% | |
Company Z | 225 | 900 | 1,050 | 107.1% | |
Company X's debt-to-asset ratio is below 44.4%, which means it is financing its operations mostly with assets. It would likely be able to obtain additional financing if needed. At 11.5%, company Y's ratio is very low compared to the other companies and would be considered the least risky of the three from a debt perspective. Company Z's ratio of 107.1%, which means it owes more in debt than it has in assets, means investors and lenders would likely consider this company a high risk.
However, any conclusions drawn from this comparison may not be entirely accurate without considering the context of the companies. For example, if the three companies are in three different industries, it makes little sense to compare them straight across. It's also important to consider which stage of the business cycle a company is in. Companies in a growth phase may take on more debt to expand operations or acquire another company so they can better support a high ratio.
It's also important to consider the context of time and how the companies' debt-to-asset ratios are trending, whether improving or worsening, when drawing conclusions about their financial conditions.
Important: The debt-to asset ratio is less effective as an apples-to-apples comparison across companies of different sizes, different industries, and different stages of growth.
Bottom Line
The debt-to-asset ratio is used to calculate how much of a company's assets are funded by debt. A high ratio indicates a company that uses debt to obtain leverage and relies heavily on leverage to finance its operations. While this may, in part, be a characteristic of its industry, it may present a higher risk of insolvency to investors and lenders.
