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.
When using this 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.
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.
To calculate the debt to assets ratio, divide total liabilities by total assets. The formula is:
Total liabilities ÷ Total assets
For example, 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 debt to assets ratio is also known as the debt ratio.