The debt ratio or debt to asset ratio is used to calculate the percentage of assets which are funded by the liabilities of a business. The ratio is an indicator of financial leverage, the extent to which the business uses liabilities 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 it is possible to make the following observations.
- 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. In this case 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 ratio of 50% is generally considered to be a satisfactory level.
How To Calculate the Debt Asset Ratio
The balance sheet below is an example to show the calculation of the debt to asset ratio.
|Long term assets||375,000|
|Total liabilities and equity||631,000|
The calculation of the ratio uses the numbers highlighted in the balance sheet shown. In the above example the total liabilities are 325,000 and the total assets are 631,000.
Accordingly using the formula the calculation of the liabilities to assets ratio is as follows.
Debt ratio = Liabilities / Assets Debt ratio = 325,000 / 631,000 = 0.515 =51.5%
In this case the ratio is 0.515 meaning that the business funds 51.5% of its assets using 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 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 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.
As an illustration of the difference in the debt ratio from industry to industry, the following table sets out the calculation of the ratio based on the Apple Inc. and Amazon balance sheets.
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 ratio Amazon (75.7%) is significantly higher than Apple (40.3%) indicating that Amazon has a higher financial leverage than Apple. The table below summarizes the results.
The 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.
Accordingly a business with a high ratio has a high level of liabilities relative to its assets and is said to be highly leveraged.
Liabilities are payable at an agreed point in time and create fixed cash outflows in comparison to the uncertain future cash inflows of the business. Consequently this mismatch of cash flows creates uncertainty over whether the business will default on its liability payments, and furthermore 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.
It is important to realize that 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 degree from Loughborough University.