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How can Debt to Assets Ratio be Improved for a Company?

Ruchi Gandhi

| Updated: Jun 01, 2020 | Category: CFO Service

Debt to assets ratio

What is meant by Debt to Assets ratio?

The debt to assets ratio is a leverage ratio close to that of debt to equity (D / E). The debt to total assets ratio is a solvency ratio, which assesses a company’s total liabilities as a percentage of its total assets. It is calculated by dividing the total debt or total outside liabilities of a corporation by its total assets employed in the business. Sometimes, it is simply referred to as a debt ratio.

To fuel in some resources into the business, a company typically resorts to equity and debt finances. It is important to measure what portion of the company’s assets is financed by debt rather than equity.

The debt to assets ratio states the overall value of the debt relative to the company’s assets. A high debt to assets ratio can become a cause of the staggering growth of the business entity and can negatively affect the creditors’ confidence in the firm. The debt ratio also demonstrates how a company has evolved over time and has accumulated its properties. This article clarifies how we should evaluate and view this formula so that we can use it to make critical financial decisions.

This ratio seeks to determine how many of the company’s assets should be sold in order to pay off the total debt of the company. It is also referred to as measuring the financial leverage of a corporation. The debt to assets ratio is computed as follows:

Debt to assets ratio = Total Outside Liabilities or Total Debt ÷ Total Assets

The debt here comprises both Short-term Debt and Long-term Debt.

The relevance of Debt to assets ratio

Contributions towards debt repayments ought to be made by a company under all conditions. Otherwise, the firm will break its loan covenants and face the risk of investors/creditors driving the firm into bankruptcy. Although other obligations such as accounts payable and long-term leases may be resolved and negotiated to some extent, there is very little scope for any relaxation in debt covenants. Hence, a corporation with a high degree of leverage can find it tougher to stay viable during a recession than one with low leverage.

The debt to assets ratio acts as a very important tool to ensure a check on the long-term financial stability of the company.

Some of the important points that exhibit the relevance and significance of debt to assets ratio are:

  • The debt to assets ratio signifies the proportion of total assets financed with debt and, therefore, the extent of financial leverage.
  • It is used to compare the gross debt of a corporation with its total capital, which consists of debt and equity financing or with total assets employed in the business.
  • The calculation is something that is used as a basis for the financial status of a company and is something that analysts consider in assessing the value of a potential transaction.
  • This measure gives an indicator of the overall financial soundness of a business as well as disclosing the proportionate debt and equity financing rates.
  • It gives an insight into the financing techniques used by a business and focus, therefore, on the long-term solvency position.
  • This ratio makes the debt rates of various organizations easy to compare. Analysts may equate the financial efficiency of one company to that of other firms within the same sector. The information may reflect how stable a firm is financially.
  • The higher the debt percentage, the greater is the level of financial leverage and, thus, the higher is the risk probability of investing in the company.
  • This estimate includes all of the company’s obligations, not just loans and bonds due, and takes into account all collateral assets and intangibles.
  • Investors use the formula to determine whether the firm has adequate funds to meet its existing debt commitments and if the business will make a return on its investment.

What is the general practice?

There is a common practice of displaying the debt in the decimal representation of gross asset ratio, which usually varies from 0.00 to 1.00. To put it in percentage terms, the ratio may fluctuate between 0% and 100%. However, any measure greater than 1 suggests that a corporation is legally insolvent and holds high financial risks (i.e., the company has more liabilities than assets). It implies that a large portion of the assets is funded with debt, and the company has a higher risk of default. So, the lower the number, the healthier the firm is.

A debt to assets ratio of 0.5 suggests that half of the company’s total assets are financed through the liabilities. In simple words, it can be said that the debt represents just 50 percent of the total assets. Similarly, if a company has a total debt to assets ratio of 0.4, it implies that creditors finance 40 percent of its assets and owners (shareholders’ equity) finance 60 percent of its assets.

Apparently, a lower ratio value is superior to a higher number. This is so because a lower level signifies a stable company with reduced debt levels. Conversely, a higher ratio means the creditors of the business can claim a higher percentage of the assets. This ultimately translates into increased operational risk, as it will be difficult to finance new projects. The higher the debt-to-asset level becomes, the more you owe, and the greater the risk you face by opening up new credit lines. Thus, it is recommended in generality that companies with higher debt to assets ratio should look to equity funding.

Assets Ratio

The necessity to improve Debt to assets ratio

For a company, a higher debt to assets ratio is rather undesirable.

The major reasons as to why a corporation must strive to improve the debt to assets ratio include the following:

  • In the first place, it suggests that a higher percentage of assets are funded through debt sources of finance. This can be construed to mean that the creditors have more claims on the assets of the business.
  • Secondly, a higher ratio further augments the challenge in securing financing for new business developments/projects because the borrowers may view the company as a volatile or risky avenue.
  • Furthermore, a higher debt to assets ratio also enhances the risk of insolvency. If the company is liquidated, with its assets, it may not be able to pay off all of the outstanding liabilities.

It is always advisable to keep the debt low in order to ensure better stability of the capital structure so that the available assets are sufficient to clean up the debt.

Ways to improve Debt to assets ratio of a company

If a business organization is reported to have a debt to assets ratio (from its financial statements), which is exorbitantly high, it needs to reduce the same. In the simplest way, to lower the ratio, the company should lower the debt proportion.

Nevertheless, some other strategies for improving the debt to assets ratio can also be followed, some of which are as mentioned below:

  • New issue or additional issue of stock: To accelerate its cash flow, the company can issue new or additional shares. This cash can be utilized for repaying current obligations and reducing the debt load in exchange. The debt reduction would, in turn, lower the debt to assets ratio.
  • Debt restructuring: If a company primarily pays relatively high-interest rates on its debts, and current interest rates are considerably lower, the business may try refinancing its existing debt. That would minimize all debt and lease costs, maximizing the company’s productivity on the bottom line and its cash resources and growing its capital reserves. This is a growing, and easy approach used to negotiate fair deals for the business and its outflows.
  • Implementation of debt/equity swap: A business may make a bond investor an equity partner in the firm by introducing a debt/equity swap. It will erase the debt owed to him and reduce the company’s liability and will further improve the ratio in effect. Convertible debentures may also be issued as necessary.
  • Leasing: A company can sell assets and then lease its properties back. This will result in an induction of cash flows that can be utilized to pay off debt obligations to some extent.
  • Proper management of inventory: Inventory can take up a very large amount of the working capital of an enterprise. Maintaining overly high inventory rates above what is needed for the timely fulfillment of consumer orders is a waste of cash flow. Organizations may analyze the ‘Days of inventory holding’ ratio as part of the cash conversion process to assess how efficiently inventory is handled. Controlling the inventories more efficiently is another step that can be taken to reduce the debt to total assets ratio.
  • Increasing sales: The organization can rely heavily on sales and revenue growth, without any rise in the corresponding operating expenses. Such an increase in sales can be used to lower the debt proportion and improve the debt to total assets ratio.

Some other capital structure ratios

Barring the debt to assets ratio, some other ratios of capital structure, which indicate the relative weight of the various sources of finance in a corporation, are as follows:

  • Equity ratio = Shareholders’ Equity ÷ Capital Employed

This ratio indicates the proportion of the owners’ funds invested in the overall fund of the company. Traditionally, it is believed that the danger level is lower when there is a higher proportion of the owners’ fund.

  • Debt to Equity Ratio = Total Debt ÷ Shareholders’ Equity

A high debt to equity ratio here signifies less protection for creditors, a low ratio, on the other hand, indicates a wider safety cushion (i.e., creditors feel the owner’s funds can help absorb possible losses of income and capital). This measure indicates the proportion of debt funds in relation to equity.

  • Capital Gearing Ratio = (Preference Share Capital + Debentures + Other Borrowed funds) ÷ (Equity Share Capital + Reserves & Surplus – Losses)

In addition to the debt-equity ratio, the capital-gearing ratio is also calculated often to highlight the proportion of fixed interest (or dividend) bearing capital to funds belonging to equity shareholders, i.e., equity funds or net worth.

Summary note

The debt to total assets ratio is a significant indicator of the long-term solvency of an enterprise. The businesses have to track this ratio constantly because creditors and potential investors will always have an eye on the ratio. The borrowers are highly concerned about getting their capital back, and a higher debt to assets ratio (raising questions over a firm’s creditworthiness) would translate into fewer or no loans for new ventures. Therefore, the organization should always try to maintain the ratio within a reasonable range.

Ruchi Gandhi

A CA together with MBA (Fin) and M Com, she relishes taking interest in insightful writing in the domain of taxation and finance. She has gained experience as a full-time author and has also served an accounting role in industry.

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