Debt to Total Asset Ratio is a ratio to determine the extent of leverage in a company. This ratio makes it easy to compare the levels of leverage in different companies. Debt to Total Asset Ratio is a very important ratio in the ratio analysis. The article clarifies how we can analyze this ratio and interpret it to use it for making important financial decisions.
Definition of Debt to Total Asset Ratio
Debt to Total Asset Ratio is a solvency ratio that evaluates the total liabilities of a company as a percentage of its total assets. It is calculated by dividing the total debt or liabilities by the total assets. This ratio aims to measure the ability of a company to pay off its debt with its assets. To put it simply, it determines how many assets should be sold to pay off the total debt of the company. This is also termed as measuring the financial leverage of the company.
How to Interpret Debt to Total Asset Ratio?
There is a general practice of showing the debt to total asset ratio in the decimal format and ranges from 0.00 to 1.00. A ratio of 0.5 indicates that half of the total assets of the company are financed by the liabilities. In other words, the debt is only 50% of the total assets.
A lower value of the ratio is better than a higher number. A lower ratio signals a stable company with a lower proportion of debt. A higher ratio means that a higher percentage of the assets can be claimed by the company’s creditors. This translates into higher operational risk as financing new projects will get difficult. Companies with higher debt to total asset ratio should look at equity financing instead.
Why Is It Necessary To Improve Debt to Total Asset Ratio?
A higher debt to total asset ratio is very unfavorable for a company.
- Firstly, it indicates that a higher percentage of assets are financed through debt. This means that the creditors have more claims on the company’s assets.
- Secondly, a higher ratio increases the difficulty of getting loans for new projects as the lenders will see the company as a risky asset.
- Thirdly, a higher debt to total asset ratio also increases the insolvency risk. If the company is liquidated, it might not be able to pay off all the liabilities with its assets.
Therefore, the company must work towards improving the debt to total asset ratio.
How to Improve Debt to Total Asset Ratio?
If a company has a higher debt to total asset ratio, it needs to lower the same. The company should reduce the debt proportion to lower the ratio. However, it can also follow several other options to improve the debt to total asset ratio:
Additional/ New Stock Issue
The company can issue new or additional shares to increase its cash flow. This cash can be used to repay the existing liabilities and in turn, reduce the debt burden. The reduction in debt will lower the debt to total asset ratio.
Debt / Equity Swap
By implementing a debt/equity swap, a company can make a debt holder an equity shareholder in the company. This will cancel the debt owed to him and in turn, reduce the debt of the company and improve the ratio. If planned, convertible debentures can be issued.
The company can sell its assets and then lease them back. This will induce a cash flow that can be used to pay off some debts.
Increase the Sales
The company can focus heavily on increasing sales but without any increase in overhead expenses. The increase in sales can be used to reduce the debt and improve the debt to total asset ratio.
Debt to Total Asset Ratio is an important solvency ratio. The company needs to monitor this ratio regularly as creditors will always keep an eye on this ratio. The creditors are worried about getting their money back and higher debt to total assets ratio will translate into no loans for new projects. Thus, the company should always aim to keep the ratio in an acceptable range.1–3