This is an advanced guide on how to calculate Debt to Asset (D/A) ratio with detailed analysis, interpretation, and example. You will learn how to use this ratio's formula to assess an organization's debt repayment capacity.
Definition - What is Debt to Asset Ratio?
The debt to asset ratio, also known as the debt ratio, is a financial calculation that allows you to evaluate a company’s leverage situation.
This is accomplished by measuring the percentage of a firm’s assets that are funded by creditors, rather than by investors.
When you want to examine a company as a potential investment, the debt to assets ratio offers a clear picture of just how much of that company’s resources are derived from borrowing money, and how much can be attributed to investor equity.
This is an important piece of information to understand, because you’ll want to feel confident that a business is capable of meeting its debt obligations, while still being in a position to offer a decent return on investment to its shareholders.
The more of a company’s assets that are funded by creditors, the higher the firm’s debt load becomes.
The more debt a business accumulates, the riskier an investment it represents, since it may eventually find itself in the unfortunate position of being unable to repay its loans.
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Formula
Calculating this ratio is very simple. The exact debt asset ratio formula looks like this:
Debt to Assets Ratio = Total Liabilities / Total Assets
While there are a number of ratio variations that focus on different aspects of comparing a firm’s debts and assets, this universal version provides a good overall measurement of a company’s solvency.
Read also: Debt to Equity - Formula, Example & Analysis
Debt To Asset Ratio Calculator
Example
Okay now let's take a look at the following example so you can understand clearly how to find debt to asset ratio in real life.
If you wanted to evaluate Company V as a potential investment, it would be helpful to have a better understanding of its leverage situation.
After examining Company V’s financial statements, you come up with the following figures:
- Total Assets = $2,000,000
- Total Liabilities = $1,000,000
By plugging these figures into the D/A formula, you end up with a result that looks like this:
In this example, Company V’s Total Debt to Total Asset ratio shows you that it has twice as many assets as it does liabilities, meaning that only half, or 50%, of its resources are derived from borrowed funds.
Interpretation & Analysis
As an investor, the debt to assets ratio can help you to evaluate the overall risk associated with a specific company.
So what is a good debt to asset ratio?
Like many financial ratios, there are three possible outcomes for a company’s total debt to total asset ratio calculation: 1, or 100%, greater than 1, or less than 1.
When the ratio value is 1, it means a firm’s liabilities are equal to its assets. In other words, 100% of its resources are financed by debt, rather than by equity.
This result is obviously not ideal from a risk perspective.
The higher the total debt to total asset ratio, the more leveraged a company is, and the greater the chance it will fall short in meeting its debt obligations.
Generally speaking, you should look for organizations with D/A ratios of less than 1, since those firms will be devoting a smaller percentage of their profits to loan payments.
This situation provides a company with some financial breathing space, should interest rates suddenly increase, or business revenues temporarily decrease.
Cautions & Further Explanation
Because the debt to total asset ratio takes such a broad look at a company’s solvency, it can’t accommodate every possible financial scenario.
While it will provide you with some insight into how well a firm’s assets support its debt commitments, the total debt to total asset ratio treats all liabilities equally.
This is the case whether debts are short-term, long-term, necessary or unnecessary to the company’s overall level of operational efficiency.
You should bear in mind that it’s not always realistic to paint all business debt with the same brush.
Depending on the industry, a higher or lower debt to total assets ratio may be considered not only acceptable, but expected.
To effectively evaluate a company's debt position, you should make use of other debt ratios, such as the cash flow to debt ratio, times interest earned ratio or debt service coverage ratio.
