What is the Debt to Assets Ratio?

The debt to assets ratio indicates the proportion of a company's assets that are being financed with debt, rather than equity. The ratio is used to determine the financial risk of a business. A ratio greater than 1 shows that a considerable proportion of assets are being funded with debt, while a low ratio indicates that the bulk of asset funding is coming from equity. A ratio greater than 1 also indicates that a company may be putting itself at risk of not being able to pay back its debts, which is a particular problem when the business is located in a highly cyclical industry where cash flows can suddenly decline. A company may also be at risk of nonpayment if its debt is subject to sudden increases in interest rates, as is the case with variable-rate debt.

Possible requirements by lenders to counteract this problem are the use of restrictive covenants that force excess cash flow into debt repayment, restrictions on alternative uses of cash, and a requirement for investors to put more equity into the company.

How to Analyze the Debt to Assets Ratio

When using the debt to assets ratio, track it on a trend line. An increasing trend indicates that a business is unwilling or unable to pay down its debt, which could indicate a default at some point in the future and possible bankruptcy. Then review the consistency of its cash flows along the same trend line. If cash flows are highly variable, this indicates an increased risk of default. Finally, review the trend line of sales and profits for the same period, to see if these amounts are declining; if so, the business is at an increased risk of eventually being unable to service its debts.

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How to Calculate the Debt to Assets Ratio

To calculate the debt to assets ratio, divide total liabilities by total assets. The formula is as follows:

Total liabilities ÷ Total assets = Debt to assets ratio

A variation on the formula is to subtract intangible assets (such as goodwill) from the denominator, to focus on the tangible assets that were more likely acquired with debt. This approach works well when a business has engaged in a large number of acquisitions, and so has a substantial amount of goodwill on its balance sheet.

Example of the Debt to Assets Ratio

ABC Company has total liabilities of $1,500,000 and total assets of $1,000,000. Its debt to assets ratio is:

$1,500,000 Liabilities ÷ $1,000,000 Assets = 1.5:1 Debt to assets ratio

The 1.5 multiple in the ratio indicates a very high amount of leverage, so ABC has placed itself in a risky position where it must repay the debt by utilizing a small asset base. The company will be in an unusually risky position if its cash flows are volatile, since it may generate so little cash in some periods that it cannot even pay the interest on its debt.