Ratio analysis is designed to reveal financial strength and weaknesses of a company. By comparing company’s ratios to industry standards and competitors. you can easily know whether its financial position has been improving or deteriorating over the years.
Before analyzing financial statements of a company, we suggest you to examine quality of financial data available to you for analysis.
To limit their investments, owners or shareholders of a company can decide for debt financing. Impact of debt financing has different implications for different stakeholders. For instance, creditors look for companies that is highly funded by shareholders as it limit their risk of recovery.
If the rate of return received from investments made by the company is higher than the interest paid to lenders, then return on owner’s capital is magnified. Due to this reason, stakeholders are interested to measure various ratios in comparison to different components. Debt to assets ratio is one of such parameter.
Debt to assets ratio determines the extent to which the business relies on outsiders/lenders to finance its assets.
Debt to assets ratio is calculated by using following formula:
Debt to assets ratio = total liabilities / total assets
Please note, total liabilities include current liabilities or short term obligations for this calculation. Creditors prefer low ratio because it provides greater cushion in the event of bankruptcy or liquidation.
You can also exclude current liabilities from the calculation, to compare long-term liabilities with the total assets. In this case, total liabilities will be considered as long-term liabilities.
Analysis of debt to assets ratio
Debt to assets ratio shows you the extent to which a company is financed with outsiders/lenders. If you want to know company’s likelihood of defaulting on its debt obligation, then interest coverage ratio might help you.
If the debt to assets ratio is high, then business assets are financed by outside creditors instead of using company’s internal funds or equity. Depending on the industry standards, if the company has a very high debt to assets ratio, then it has higher risk for creditors and investors. However if the interest coverage ratio is high, then you as a investor should not be worried.
A low ratio indicates that the company is funded by its owners or shareholders. In this case, creditors will be interested to lend the business if the net profit margin can cover the repayment of debts.
If debt ratio increases beyond industry standards then it raises a red flag. To come out of this trap, company has to look for options of raising more money through equity capital or start selling some of its assets.