Understanding Debt to Assets Ratio

The debt to asset ratio is a solvency metric that indicates how much of the company's assets are capitalized by debts. In other words, it shows how much portions of a company's assets are financed by debts and equity. Or we can say that it indicates the financial stability of the company. It is calculated as total debts divided by total assets. Total debts include short-term as well as long-term debts.

The formula to derive Debt to Asset Ratio



Total Debt - It is a sum of the company's long-term debts and short-term debts. And it is found in the company's liabilities section of the Balance Sheet.

Total Assets - Total assets are the total value of assets owned by the company. Total assets are reported on a company's balance sheet.

Example of Debt to Asset Ratio: For the financial year, Hindustan Copper Limited reported total debt as Rs.1166.43 Cr. and total assets as Rs. 2837.83 Cr.
The value as per the formula (Total Debt / Total Assets) is calculated as (1166.43 / 2837.83) = 0.41.

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Key Highlights

As an indicator of the company's solvency, the debt to asset ratio shows how much of the company's assets are financed by debt.

The debt to asset ratio is calculated as total debt divided by total assets.

When the economic or other factors affect companies, then the companies with a low debt to asset ratio have a high chance to survive, and that's why a low ratio is considered less risky.

A low debt to asset ratio is considered better than a high ratio.

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While looking at the Debt to Asset Ratio, the following points should also take into consideration:

Generally, a ratio below 0.5 is considered good as it indicates that the company's more assets are funded by using equity than debts. The debt to asset ratio is expressed in absolute number or percentage. Based on the example above, Hindustan Copper Limited has a debt to asset ratio of 0.41, which means 41% of its assets are financed by debt.

If the debt to asset ratio is 0.5, then it means that the company's assets are equally funded using debts and equity.

A high ratio indicates a weak solvency position of the company as more assets are funded using debts. Companies with a high ratio are acceptable if their cash flow is stable, but the ratio should be less than 0.75. High debt is not acceptable for companies with unstable cash flows.

A ratio above 1 indicates that a large portion of the company's assets is capitalized by debts or has more liabilities than assets. Sudden change or rise in interest may affect the company in the worst way if the ratio is above one.

When the economic or other factors affect companies, then the companies with a low debt to asset ratio have a high chance to survive, and that's why a low ratio is considered less risky. The importance of the debt to asset ratio is that it shows how much of the company's assets are in the hands of the investors and creditors.

Capital intensive companies may have a high debt to asset ratio relative to other companies (like IT and services). Capital-intensive companies need a huge capital to invest in projects or assets, so their debts are also high. And companies that operate in IT or Services industries need less amount of assets compared to capital-intensive companies.

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How to use the Debt to Asset Ratio effectively

Investors should look for companies with a low debt to asset ratio as those companies are considered less risky and financially strong.

While doing analysis, also looks at the company's historical data to understand past performance. It is a positive sign if the debt to asset ratio is decreasing over a year as it indicates that the company is reducing its debt or acquiring more assets using equity capital.

Companies that operate industries like software, financial, service, etc., are most likely to have a low ratio compared to capital-intensive companies.

Always compare companies that operate in the same industry as it differs from one industry to another. And while analyzing companies' debt to asset ratio, also check other relative financial metrics for better analysis such as Debt to Equity Ratio, Shareholders' Equity Ratio, Return on Assets (ROA), etc.

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