For most companies, taking on debt is a necessary step in financing. Just as an individual can dig himself into a hole with credit card debt, a business with too much debt may find itself unable to pay back principal and interest. The debt-to-net assets ratio measures how much debt a company holds relative to available resources for debt repayment. The higher the ratio, the more leveraged a company is.
Debt to Net Assets Ratio
The debt-to-net assets ratio, also known as the debt-to-equity ratio or D/E ratio, is a measure of a company's financial leverage. Since debts represent amounts the company must repay and net assets represent assets free of obligations, the ratio indicates what ability the company has to repay debts. Creditors often calculate this ratio when making lending decisions. If a company has a high ratio, a lender may only lend at a very high interest rate or not lend at all.
The two components of the debt ratio are total liabilities and net assets. Even though it's called the debt ratio, you must use all liabilities, not just debt, to calculate the ratio. Total liabilities include both short-term liabilities and long-term liabilities. Typical short-term liability accounts are accounts payable, interest payable and the current portion of long-term debt while typical long-term liability accounts include bonds payable and loans payable. Sum all liabilities to calculate total liabilities. For instance, if short-term liabilities are $5,000 and long-term liabilities are $15,000, total liabilities equal $20,000.
Net assets are total assets less total liabilities. For example, if total assets are $120,000 and total liabilities are $20,000, net assets are $100,000. Net assets are also equal to total stockholder's equity. As an alternative, you can sum all stockholder equity accounts -- typically, common stock, paid-in-capital and retained earnings -- to calculate net assets.
Calculating and Interpreting the Ratio
To calculate the debt ratio, divide total liabilities by net assets. In this example, a company with total liabilities of $20,000 and net assets of $100,000 has a debt ratio of 0.2. Compare this debt ratio with debt ratios from the last few years. If the number is decreasing, that means that the company has either been paying down its debt or has increased its assets relative to the debt it holds. If the number is increasing, that means that more of the business is being financed by debt and it may have trouble paying back its loans.
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