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What Is A Good Debt To Asset Ratio And How Do You Calculate It

Uncontrolled debt can significantly take a toll on an individual’s financial and mental health, especially if you don’t know how to manage it properly. Still, businesses and individuals choose debt to fuel their growth globally.

Whatever your case may be, calculating the debt to asset ratio can help ascertain your net obligations and financial health. Investors calculate it before investing in a company and lenders before lending money to an individual or company.

A good debt to asset ratio means you have less or nil liabilities. In contrast, a bad debt to asset ratio means the opposite. But what figures are considered good or bad? How to calculate it? Let us understand step-by-step in the following paragraphs. Meanwhile, visit this page if you are looking for guidance on consolidating your debt into a mortgage.

Debt To Asset Ratio: An Introduction

Commonly known as debt ratio, it is calculated to determine the net debt a business or an individual is carrying to finance their asset. The higher the debt ratio, the greater the financial risk factor.

To put it simply, it tells how much a debt a company carries, its repaying capacity, and chances of availing the next debt. Investors and lenders commonly use it to ascertain a company’s overall risk.

Unlike credit scores, a higher debt ratio means higher liabilities and risk. On the other hand, the creditors consider lower ratios more favourable. When taken as a percentage, it shows the percentage of assets funded by the debt.

What Is A Good Debt To Asset Ratio?

While debt ratio is a vital marker for the financial health of an individual or company, corroboration with other factors is also necessary.:

• Generally, a ratio below .3 is considered favourable for investors and creditors. It means their funds rather than debts finance a company’s assets or individuals.
• A score between 0.3 to 0.6 is considered safe. As the ratio increases, liabilities also increase.
• Above 0.6 is considered risky. In this category, most of the assets are financed by debt.

From an investor point of view, a company has a debt to asset ratio:

• Equal to one (=1) shows the company owns assets the same as its liabilities.
• Greater than one (>1) shows more debt than assets.
• Less than one (<1) shows the company owns more assets than liabilities.

Considering the above figures, it can be concluded that companies or individuals with high debt to asset ratios are more leveraged by debt. Hence, riskier from an investor and creditor point of view.

How To Calculate The Debt To Asset Ratio?

A creditor or investor first analyses a company’s balance sheet to calculate the debt to asset ratio. Beyond financing purposes, the debt to asset ratio is often calculated by companies to ascertain their growth and financial position. Generally, the following steps are followed to calculate the debt ratio:

1. Calculate the total liabilities
2. Calculate the total assets
3. Put the figures in debt to asset ratio formula and calculate it.

1. Calculate Total Liabilities

The first step is calculating the net liabilities of a company. Formula to calculate net debt:

Net debt = Short term debt (current liabilities) + Long term Debt)

Where:

• Short-term debt means short-duration liabilities. Generally, less than one year. It is also referred to as current liabilities.
• Long-term debt means a financial obligation that has to be paid in more than one year.

For instance, a company often avails small business credits to fuel its requirements. Additionally, it is also funded by the creditors throughout its operation.

2. Calculate Total Assets

The second step is calculating total assets. Total assets include cash in hand, cash equivalents, investments, movable and immovable properties. Add all figures to calculate the total asset of your company.

3. Calculate Debt To Asset Ratio Using The Formula

Generally, companies reflect their total debts and total assets in their balance sheets with other figures. To put the figures in the formula, take net debt as dividend and net asset as the divisor. Divide it to get the debt to asset ratio figure.

Put the values in the following formula to calculate the debt to asset ratio:

Debt to Asset Ratio = Net Debt / Total Assets

Example For The Calculation Of Debt To Asset Ratio

We have tried to simplify the calculation with the help of an example. Let us take an example of XYZ company with the following balance sheet:

 Balance Sheet FY-2020 Asset Type Current Assets 250,000 Fixed Assets 0 Other Assets 0 Liabilities Current Liabilities 30,000 Long-term Liabilities 20,000 Owner Equity 0 Total Assets 250,000 Total Liabilities & Stockholder Equity 50,000 Balance 200,000

From the above balance sheet, we can put the values in debt to asset ratio formula:

Debt/Asset = (Short-term Debt + Long-term Debt) / Total Assets

In this case, net assets amount to \$250,000

Net debt= {Short (Current) debt + Long term debt} = \$30,000 + \$20,000 = \$50,000

Therefore, calculate the debt ratio using the formula:

Debt/Asset  = \$50,000 / \$250,000 = 0.2 = 20%

Interpreting The Debt To Asset Ratio

The resulting percentage in the given example is 20%. Therefore, from the above calculation, it is figured out that company XYZ’s 20% assets are leveraged by debt. It is an impressive figure for a company or an individual.

Any debt ratio higher than 0.8 or 80% is not considered favourable by investors and creditors. A higher ratio is a clear indicator of financial risk associated with an individual or company.

Conclusion

To summarize, the lower the debt asset ratio, the more favourable the debt to asset ratio is. But it is necessary to understand the debt ratio varies significantly from one industry to another.  Hence, to determine the overall financial health of a company, consider other benchmarks too.

Similarly, in the case of an individual, other calculations such as debt to income ratio play a vital role. However, calculating the debt to asset ratio remains a standard practice to ascertain a company’s financial health and debt leverage.