Definition
Companies have two options for acquiring assets: using its own capital, or borrowing funds from a third party. The balance between assets owned and borrowed has implications for the company’s financial future and level of risk. It is worth becoming familiar with an important accounting technique that simplifies this process: the debt to asset ratio.
The debt to asset ratio is a leverage ratio that identifies the portion of assets that are funded through debt. It is extremely useful for analyzing financial risk. A company that owns more of its holdings is in a more secure position than a company that is overleveraged. The riskier company would have a higher debt to asset ratio, which signals to analysts, investors, and creditors that the company may become illiquid or no longer be able to pay its liabilities.
Accountants calculate the debt to asset ratio to inform management, analysts, creditors, and investors alike. It provides a useful overview of how a company has grown and acquired its holdings over its life, as well as a forecast of its solvency in the future. Creditors reference the debt to asset ratio to assess the amount of liability in a business, whether a business can repay those debts, and whether the business will receive additional loans. On the other hand, investors use the debt to asset ratio to ensure that a company is solvent and able to generate a return on investments. Business owners that want to expand their financing options, rather than be skipped over by wary investors and creditors, would benefit from understanding the debt to asset ratio and why it is such a crucial step in the accounting process.
How to Calculate Debt to Asset Ratio
The debt to asset ratio is relatively easy to calculate. We simply divide total liabilities by the company’s total assets. For example, suppose we own a company that has total holdings of $101,000 and total liabilities of $16,000. Using the formula, we simply divide $16,000 by $101,000. The ratio of Debt to assets is 1584 or 15.84%.
Interpreting Results
Now that we have calculated a ratio in the example above, what insights can we draw from the result? The debt to asset ratio tells us the percentage of a company’s holdings that are leveraged. We’re now able to understand the balance between holdings financed by borrowed funds versus those financed by the company’s own capital.
A higher debt to asset ratio indicates that if a company does not pay off its debts, the loan holder may repossess that capital. This can be a hard blow to a company that is already having a hard time paying off its liabilities. It is usually riskier to invest in or provide loans to a company with a higher ratio.
On the other hand, a lower debt to asset ratio indicates that a company owns more of its holdings outright. The company will keep those holdings even if there is a downturn in the market and the company is low on cash. Companies in this position pose a relatively lower financial risk for investors and creditors.
The debt to asset ratio, while crucial to the accounting process, requires some context if we really want to understand its meaning. After calculating a ratio, we need to compare it with past results and industry data and see if there is a significant difference. This is because higher debt to asset ratios are standard in some industries, such as real estate.
If you own a business, the last thing you need is to spend your precious time on paperwork and tedious calculations. So, leave your bookkeeping to expert accountants who will do the math for you! Check out BooksTime to find out more about accounting services that can help get you on the track to financial success, while you focus on running your business.
