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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.
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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:
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.
Read, Also: Critical Financial Performance Ratios to Track a Start-up’s Liquidity, Profitability, and Solvency.
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:
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.
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:
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:
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.
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.
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.
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.
Also, Read: Capital Adequacy Ratio [CAR] – Definition, Calculation and Importance.
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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