The debt ratio or debt to asset ratio is used to calculate the percentage of assets funded by the liabilities of a business. The ratio is an indicator of financial leverage, the extent to which the business uses debt instead of equity to finance its operations.
Debt Ratio Formula
The definition used by the template includes all liabilities both current and long term liabilities, interest bearing or not. Expressed in this way, the ratio can also be referred to as the liabilities to assets ratio.
Both liabilities and assets are found on the balance sheet of the business.
Understanding the Debt to Assets Ratio Formula
Using the formula the following observations can be made.
- If the liabilities are equal to zero, then the debt to asset ratio is equal to zero. None of the assets are funded by liabilities and must therefore all be funded by equity.
- When the liabilities are equal to the assets the debt to asset ratio is equal to one. The assets are funded entirely by liabilities, and the business is said to be highly leveraged.
- When the debt to asset ratio is 50%, the assets are 50% funded by liabilities and 50% funded by equity. Every type of industry will have its own benchmark debt to asset ratio, however, a debt ratio of 50% is considered to be a satisfactory level.
How To Calculate the Debt Asset Ratio
The balance sheet below is used as an example to show how the debt to asset ratio is calculated.
|Long term assets||375,000|
|Total liabilities and equity||631,000|
The numbers used in the calculation of the debt ratio are highlighted in the balance sheet shown. In the above example the total liabilities are 325,000 and the total assets are 631,000.
Using the formula the liabilities to assets ratio is calculated as:
Debt ratio = Liabilities / Assets Debt ratio = 325,000 / 631,000 = 51.5%
In this case the ratio is 0.515 meaning that 51.5% of the assets used within the business are funded by liabilities. The balance of the assets (48.5%) must therefore be funded by equity, mainly capital injected by investors and retained earnings of the business.
Alternative Form for the Debt to Asset Ratio
The accounting equation tells us that Assets = Liabilities + Equity. If we substitute assets for liabilities plus equity in the debt to asset ratio formula we get the following.
Debt ratio = Liabilities / Assets Debt ratio = Liabilities / (Liabilities + Equity)
Using the same balance sheet as in the example above, the calculation is as follows.
Debt ratio = Liabilities / (Liabilities + Equity) Debt ratio = 325,000 / (325,000 + 306,000) = 51.5%
Real Life Liabilities to Assets Ratio Examples
The debt ratio will vary from industry to industry, and therefore it is important when making comparisons, to determine an industry ratio benchmark based on financial statements of businesses similar to your own.
Apple: Debt ratio = Liabilities / Assets Debt ratio = 83,451 / 207,000 = 40.3% Assets funded by liabilities = 40.3% Assets funded by equity = 59.7% Amazon: Debt ratio = Liabilities / Assets Liabilities = 22,980 + 3,191 + 4,242 = 30,413 Debt ratio = 30,413 / 40,159 = 75.7% Assets funded by liabilities = 75.7% Assets funded by equity = 24.3%
The debt ratio of Amazon (75.7%) is significantly higher than Apple (40.3%) indicating that Amazon is more highly leveraged than Apple. The results are summarized in the table below.
Debt Ratio and the Financial Projections Template
The debt to asset ratio is reported on the ratios page of the financial projections template. The ratio should be monitored to ensure that it is consistent with the industry in which the business operates.
The higher the debt to asset ratio, the higher the financial leverage, and the higher the risk.
A business with a high debt to asset ratio has a high level of liabilities relative to its assets and is said to be highly leveraged.
Liabilities need to be paid at an agreed point in time and create fixed cash outflows in comparison to the uncertain future cash inflows of the business. This mismatch of cash flows creates uncertainty over whether the business will default on its liability payments, and presents a risk to the equity investors, who can only be repaid after the liabilities have been settled.
It is for this reason that in general businesses with stable and predictable cash inflows are seen as less risky than those with highly volatile cash inflows.
High leverage is not necessarily a bad thing. Providing the return the business makes is greater than the cost of the debt (interest), high leverage can lead to greater returns for the owners of the business.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.