Debt to total assets ratio
Total debt to total assets ratio is one of leverage ratios, that presents the percentage of the share of the creditors to the total assets of the business. It is calculated by dividing total liabilities to total assets[1]. Assets take into account current and non- current assets of a company, as debts include both current liabilities and long-term liabilities. Enterprises endeavor to obtain low result of this ratio, because it means that the owners have more claims to the assets of the company than creditors[2].
Leverage Ratios
Leverage ratios according to M. Pozolli and F. Paolone "is any one of several financial measurements that look at how much capital comes in the form of debt (loans) or assesses the ability of a company to meet its financial obligations" [3]. These ratios are often called long-term solvency ratios [4].
The category of leverage ratio is important because companies finance their operations using a mix of equity and debt, and knowing the amount of debt held by the company is useful in assessing whether it can repay its debt on time [5]. Knowing the amount of debt which is held by the company is useful in assessing, if it can repay its debt on time.
How to calculate Total Debt to Total Assets ratio?
The formula is:
How to Use the Total Debt to Total Assets Ratio?
Let's have a look at the total debt to total assets ratio for three companies - Company X, Company Y, Company Z - for the end of fiscal year, 2018.
| The data is presented in millions of USD | Company X | Company Y | Company Z |
|---|---|---|---|
| Total Debt | 49,889 | 672.5 | 14,268 |
| Total Assets | 96.541 | 2265.15 | 10,256 |
| Total Debt to Assets | 0.52 | 0.29 | 1.39 |
From the provided example, Company Z has a much higher degree of leverage, than Company X and Company Y, so as the results this Company has a lower degree of financial flexibility. Such a financial situation (high level of indebtedness) may lead to the declaration of bankruptcy. Investors and creditors may consider such a company risky because it invests and borrows due to very high leverage.
Conclusions:
- Ratio's result higher than 1, presents that a company has more liabilities than assets, i.e. a significant part of the debt is funded by assets.
- A high ratio may mean that an enterprise may run the risk of default on its loans, if interest rates suddenly increase.
- A ratio below 1 presents that the major part of the company's assets is funded by equity.
Examples of Debt to total assets ratio
- The debt to total assets ratio of Company X is 0.55, which means that the company has 55% of its assets financed by debt.
- The debt to total assets ratio of Company Y is 0.40, indicating that 40% of the company’s assets are funded by debt.
- The debt to total assets ratio of Company Z is 0.15, meaning that just 15% of the company’s assets are financed by debt.
- The debt to total assets ratio of Company A is 0.00, indicating that the company has no debt and all of its assets are funded by equity.
Advantages of Debt to total assets ratio
Debt to total assets ratio has several advantages:
- It allows for a quick assessment of the financial leverage of the business. It is a measure of how much of the business is financed by debt and how much is funded by equity.
- It is used to evaluate the risk of the business, as it indicates the level of financial leverage. It helps to determine whether the business has taken on too much debt and if it has the capacity to pay its debts.
- It also helps to measure the financial stability of the business, as it indicates the extent to which the business is dependent on debt to finance its operations.
- It is a useful tool for creditors to evaluate the financial strength of the business. It also helps investors to assess the risk associated with investing in the business.
Limitations of Debt to total assets ratio
The debt to total assets ratio is a useful tool for evaluating a company’s financial health and leverage, however, it has some inherent limitations. These include:
- The ratio does not take into account the specific components of the liabilities, such as short-term versus long-term debt, which could have different implications for the company’s financial health.
- The ratio does not factor in the quality of the assets, and thus cannot provide a true picture of the company’s financial position.
- It does not account for the cash flow situation of the company, which could be a critical factor in the company’s financial health.
- It does not take into account any non-financial assets, such as intangible assets, which could also be important indicators of the company’s financial performance.
- The ratio does not consider the interest rate of the debt, which could be an important factor in determining the company’s financial health.
One of the related approaches to the debt to total assets ratio is the following:
- Debt ratio - This is calculated by dividing total liabilities by total assets. It measures the percentage of the company's assets that are financed by debt.
- Debt-to-Equity Ratio - This is calculated by dividing total liabilities by total equity. It measures the percentage of the company's assets that are financed by debt relative to the amount of equity financing.
- Interest coverage ratio - This is calculated by dividing operating income by interest expenses. It measures the ability of a company to pay the interest expenses on its debt.
- Debt Service Coverage Ratio - This is calculated by dividing net operating income by total debt service. It measures the ability of a company to pay its debt service obligations.
In summary, the Debt to Total Assets ratio is one of the leverage ratios used to measure the percentage of the company's assets that are financed by debt. Other related approaches include the Debt Ratio, Debt-to-Equity Ratio, Interest Coverage Ratio, and Debt Service Coverage Ratio.
Footnotes
| Debt to total assets ratio — recommended articles |
| Capitalization ratios — Capitalization ratio — Debt management ratio — Solvency ratios — Asset coverage ratio — Coverage ratio — Fixed-Charge Coverage Ratio — Asset equity ratio — Cash Flow-to-Debt Ratio |
References
- Agatrap - San Juan D. (2007), Fundamentals of Accounting: Basic Accounting Principles Simplified for Accounting Students, AuthorHouse, Bloomington, p. 331-337
- Buljevich E., Park Y. (1999), Project Financing and the International Financial Markets, Springer Science & Business Media, Norwell, p. 133-138
- Colla P., Ippolito F., Kai L. (2013), Debt specialization, "The Journal of Finance", No. 68.5, p. 2117-2141
- Lin C., Ma Y., Malatesta P., Xuan Y. (2013), Corporate ownership structure and the choice between bank debt and public debt, "Journal of Financial Economics", No. 109(2), p. 517-534
- Nikolai L., Bazley J., Jefferson J. (2010)., Intermediate Accounting, Eleventh Edition, Cengage Learning, Mason, p. 284-285
- Parrino R., Kidwell D., Bates T. (2011), Fundamentals of Corporate Finance 2nd Edition, John Wiley & Sons, Haboken, p. 93-96
- Pozzoli M., Paolone F. (2017), Corporate Financial Distress: A Study of the Italian Manufacturing Industry, Springer, Naples, p. 30-33
- Van der Wijst N., Thurik R. (1993), Determinants of small firm debt ratios: An analysis of retail panel data, "Small Business Economics", No. 5.1, p. 55-65
- Welch I. (2011), Two common problems in capital structure research: The financial‐debt‐to‐asset ratio and issuing activity versus leverage changes, "International Review of Finance", No. 11(1), p. 1-17
Author: Katarzyna Skrzyniarz
