A debt-to-asset ratio is a financial ratio used to assess a company's leverage – specifically, how much debt the business is carrying to finance its assets. Sometimes referred to simply as a debt ratio, it is calculated by dividing a company's total debt by its total assets. Average ratios vary by business type and whether a ratio is "good" or not depends on the context in which it is analyzed.
TL;DR (Too Long; Didn't Read)
From a risk perspective, a lower ratio is better. But what constitutes a "good" debt ratio really depends on your industry.
Doing the Math
The formula for the debt-to-asset ratio is simply:
Debt-to-Asset = Total Debt/Total Assets
When figuring the ratio, add short-term and long-term debt obligations together. Then add intangible and tangible assets together. Divide debt by assets and convert the answer to a percentage. For example, the debt ratio for a business with $10,000,000 in assets and $2,000,000 in liabilities would be 0.2. This means that 20 percent of the company's assets are financed through debt.
What it Indicates
The resulting percentage taken from calculating this ratio shows what portion of the company's assets is financed through borrowing and is used as an indicator of a company's ability to meet those debt obligations. A lower debt-to-asset ratio suggests a stronger financial structure, just as a higher debt-to-asset ratio suggests higher risk. Generally, a ratio of 0.4 – 40 percent – or lower is considered a good debt ratio. A ratio above 0.6 is generally considered to be a poor ratio, since there's a risk that the business will not generate enough cash flow to service its debt. You may struggle to borrow money if your ratio percentage starts creeping towards 60 percent.
To contextualize debt-to-asset ratio and risk, the idiosyncratic characteristics of the industry must be considered in the analysis. For example, Starbucks Corp. listed $3,932,600,000 in long-term debt on its balance sheet for the fiscal year ended October 1, 2017, and its total assets were $14,365,600,000. Their debt ratio is $3,932,600,000 ÷ $14,365,600,000 = 0.2738, or 27.38 percent. To determine whether this is a high ratio, the capital expenditures common to this type of business impact the equation. With 23,768 locations in 74 countries, Starbucks costs include leasing and customizing commercial space, purchasing specialized equipment, and training and hiring employees in an industry with an extremely high turnover. In addition, they must adhere to countless food safety regulations and other costs associated with the food industry. Morningstar, a global investment researcher, lists the industry average debt ratio as 40 percent. Based on an overall assessment, Starbucks' financial position is solid. They can easily borrow money because creditors trust they will be paid back in full.
When a business finances its assets and operations mainly through debt, creditors may deem the business a credit risk and investors shy away. However, one financial ratio by itself does not provide enough information about the company. When considering debt, looking at the company’s cash flow is also important. These figures looked at along with the debt ratio, give a better insight into the company's ability to pay its debts.
Debt-to-Asset Ratio Variables
A debt-to-asset ratio provides information for one point in time. Therefore, analysts, investors and creditors need to see subsequent figures to assess a company's progress toward reducing debt. In addition, the type of industry in which the company does business affects how debt is used, as debt ratios vary from industry to industry and by specific sectors. For example, the average debt ratio for natural gas utility companies is above 50 percent, while heavy construction companies average 30 percent or less in assets financed through debt. Thus, to determine an optimal debt ratio for a particular company, it is important to set the benchmark by keeping the comparisons among competitors.