All you need to know about the Debt Ratios: Debt-to-Assets | Total-Debt-to-Total-Assets
This is important because:
The formula for debt ratio, debt-to-asset ratio and total-debt-to-total-assets (TD/TA) ratio is:
Total Debt / Total Assets
Both current and non-current forms of debt are included in the calculation:
Total Debts (= Short-term Debt + Long-term Debt)
Company A has a debt ratio of 0.3 or 30% (= 300,000 / 1,000,000)
The debt ratio is a finance ratio that represents the degree to which an entity has used debt (as opposed to equity) to finance its assets by calculating the proportion of the entity’s assets that are financed through debt.
Debt ratio equal to 1 (=100%) means that an entity has the same amount of liabilities as its assets.
|Debt ratio | Debt-to-Asset ratio | Total-Debt-to-Total-Assets ratio (TD-TA)
|Leverage & Risk
|Debt > Assets
|Entity has more debt/liabilities than assets, more debt funded by assets and also more assets financed by debt.
|Debt = Assets
|Entity has the same amount of debt as assets.
|Debt < Assets
|Entity has more assets than debt/liabilities and more assets funded by equity, resulting in higher creditworthiness and appeal for lenders and investors.
|Debt << Assets
|Entity has the safest financial risk and credit profile, with the most financial stability, borrowing capacity and flexibility.
Typically, the debt ratio analyzes the statement of financial position of a company by using the following balance sheet items in the calculation:
However, these are just the general guidelines.
The debt ratio is sometimes defined in different terms, for example:
|Debt Ratio Variations & Alternatives
|Takes into account long-term debts only.
|The formula is total liabilities divided by total assets.
|This ratio is more common than the debt ratio and also uses total liabilities in the numerator.
|Custom ratio model
|Analysts may choose to only include certain classes of assets and/or liabilities into the calculation at their discretion.
There is no absolute number–or even firm guidelines–for a ‘safe’ maximum debt ratio.
What is ‘good’ depends on a wide variety of contextual factors.
The main reason is that interest on borrowing must be paid regardless of whether the business is generating cash or not. Therefore, excessively leveraged companies may become unable to service their debt, forced to sell off important assets, or– in the worst case scenario–declare bankruptcy.
That’s why higher debt ratio makes it more difficult to borrow money. Lenders often have debt ratio limits and do not extend credit to over-leveraged companies.
While a low debt ratio leads to better creditworthiness, having too little debt is also risky.
A low–or even zero–debt ratio suggests that the company does not finance its operations through debt at all, which limits the total returns that can be generated by the business–and ultimately passed on to owners/investors/shareholders.
That’s why investors are often not too keen to invest into under-leveraged businesses.
As with all other ratios, to get a more accurate picture, the debt ratio should be evaluated in context, including the following 3 considerations:
Despite the 0.5/50% recommended threshold, debt ratios vary widely across industries:
|Typical debt ratio industry average
|> 2.0 / 200%
|Around 1.0 / 100%
|eCommerce, online services
|< 0.5 / 50%
For instance, capital-intensive companies with stable cash flows operate successfully with a much higher debt ratios.
Also, the more established a company is, the more stable cash flows and stronger relationships with lenders it tends to have. As a result, larger and more mature companies can typically afford to have higher debt ratios than other industries.
Hence, benchmarking is an essential part of ratio analysis, where you compare companies of a similar size and business model in the same industry.
In addition, the trend over time is equally as important as the actual ratio figures.
The trend analysis of historical performance will show how the company has acquired and grown its assets and how its financial risk profile is evolving.
For example, if the ratio of a company is over 50%, or even 100%, and further deteriorating over time, it is worth to examining its debt position in more detail. It could indicate that the company is unwilling or unable to pay off its debt–now or in the future.
The obvious limitation of a debt ratio is that it does not provide any indication of asset quality because it uses all types of assets and liabilities combined together.
Also, interest rates should be taken into consideration. The same principal is less expensive to pay off at a 5% interest rate than it is at 10%.
Another key factor that matters in debt ratio evaluation is the perception of stakeholders.
Used in combination with other measures of financial health, the debt ratio can help stakeholders determine the risk level of a company. For example:
Debt ratio applies to you too!
Debt ratios are used to assess the financial risk and health of not only businesses, but also non-profits, governments–and individuals.
Banks and other credit providers will examine your own debt ratio (debt to asset/income) to determine if–and how much–they are willing to lend you for your business, home or other personal needs.
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