The Debt-to-Assets Ratio

You spend hours scouring the internet to find the perfect stock that fits well in your portfolio, and it comes down to four or five stocks that are about the same size as well as in similar industries; but which one is the best out of the lineup? Investors often use solvency ratios like debt to equity, debt to capital, interest coverage and debt to assets to determine how financially healthy a company is based on how it manages its short- and long-term debt.

Solvency formulas like the debt-to-assets ratio can help investors gain insights into how a company stands up against its peers.

In this article, we cover how to calculate the debt-to-assets ratio, what it is and how investors can utilize this key financial metric to screen for financially healthy stocks.

What Is the Debt-to-Assets Ratio?

The debt-to-assets ratio, also commonly referred to as the debt ratio, measures a company’s use of leverage. In other words, it tells you the percentage of debt used to finance assets, which can include both tangible resources, including property, production materials or equipment, as well as intangible resources, such as patents or trademarks. The debt-to-assets ratio includes the company’s short- and long-term debts.

The debt-to-assets ratio is considered a solvency ratio because it expresses how leverage is used and indicates how much of the business is funded by debt versus assets. A solvent company is one that owns more than it owes; therefore, the debt-to-assets ratio can help investors to understand the company’s debt situation. This can help determine whether it is financially healthy and stable.

How to Calculate the Debt-to-Assets Ratio

Understanding how to calculate the debt-to-assets ratios for a business is important in order to compare companies in similar industries to see how they’re managing their debt and leverage.

Don’t worry, you won’t need a debt-to-assets ratio calculator for this; even beginning investors can calculate this metric on their own. The debt-to-assets ratio formula is as follows:

 Debt-to-Assets Ratio = Total Debt ÷ Total Assets

You can find a company’s total debt and total assets on its balance sheet. Remember, for total debt, you will need to include both short- and long-term debt. Total assets may include all current and non-current assets. Different companies may calculate total assets differently based on the accountant’s discretion and calculations; therefore, it’s important to compare “apples to apples” and ensure that total assets is calculated in the same way for any companies you are comparing.

The debt-to-assets ratio formula is important to calculate because it tells you how solvent a company is, which will help you to decide if you should invest your money into the business or not.

Additionally, calculating the debt-to-assets ratio formula on your own provides you with an idea of how the company’s current business model is structured to meet current and future obligations, as well as generate a positive return each quarter.

What Is a Good Debt-to-Assets Ratio?

If you’ve done your research and calculated your debt-to-assets ratio, how do you know what a good debt-to-assets ratio is versus a poor one? This answer depends heavily on the company’s specific industry. Generally, a good debt-to-assets ratio is one that is low because it indicates that a company relies less on borrowing debt to finance its assets.

A lower debt-to-assets ratio, all else equal, suggests a stronger financial structure, and a higher debt-to-assets ratio may suggest higher risk for the investor or creditor. Overall, it’s important to understand the company’s industry, but a good debt-to-assets ratio will be lower than that of its peers.

What Does a High Debt-to-Assets Ratio Mean?

If you find that the debt-to-assets ratio is significantly higher than that of the company’s industry peers, this may indicate that a significant portion of assets is funded with debt. This signals an overall higher default risk, especially for a small-capitalization company.

Default risk measures the likelihood that a borrower will fail to repay their loan obligations. A borrower has a higher default risk when they have a poor credit rating and limited cash flow. For an investor, it means that the company may not be able to effectively pay off its debts or regain revenue from its investments, which could put the company at risk of bankruptcy. This usually pertains to mid- and small-cap companies that don’t have the same level of financial backing that large caps do.

So, is a high debt-to-assets ratio good or bad? The answer depends on evaluating other areas of the business. For example, companies in the finance industry typically have higher debt-to-equity ratios because these companies leverage a lot of debt, especially when they use this debt to grant loans in order to make a profit. For investors looking at stocks in the finance industry, a high debt-to-assets ratio may not be enough information to determine if it’s a stable company or not. You should look at other solvency ratios to decide whether to invest.

On the other hand, the service industry and the health care industry both tend to have lower debt-to-equity ratios because they have fewer assets to leverage. If you’re looking at a stock in the service industry, you may want to watch out for high debt-to-assets ratios and stick with those that that are significantly below 1.0.

What Does the Debt-to-Assets Ratio Tell Investors?

Investors looking at multiple companies in the same industry use the debt-to-assets ratio to evaluate whether the company has enough funds to meet its current debt obligations and to assess whether the company can generate revenue on its investments. Investors are interested to understand the company’s overall business model because repaying debts and managing its financials can be a major strain on a business, significantly reducing its overall profit margin, which can cause the stock price to fluctuate.

Additionally, growth investors can use the debt-to-assets ratio to evaluate how a company has managed its short- and long-term debts over several years, which indicates if a company has grown or not.

Are There Limitations of Using the Debt-to-Assets Ratio?

As with any financial metric, there are always associated limitations when it comes to using the debt-to-assets ratio. That’s why we stress that investors will need to analyze multiple ratios and other metrics to determine if a company is solvent or not. A few of the limitations of the debt-to-assets ratio include:

• You must use the same terms in the numerator and denominator of the equation to ensure that you are comparing companies in the same industry correctly.
• Companies may report different numbers for their total assets and total debts if they have varied accounting practices.
• The debt-to-assets ratio does not provide any indication of asset quality since it lumps all tangible and intangible assets together into one number.

Like we mentioned above, all financial metrics have benefits and limitations, that’s why it’s crucial to be aware of these before you calculate the debt-to-assets ratio.

How to Determine the Debt-to-Assets Ratio From a Balance Sheet

So, now that you understand how to calculate debt-to-assets ratio and what it can tell you as an investor, you may be wondering how to find the debt-to-assets ratio. To calculate the debt-to-assets ratio, you will need two numbers: total assets and total liabilities (also known as total debt), both located on the balance sheet.

You can easily find a company’s balance sheet by downloading its 10-K statement, which includes its annual report with fiscal year-end financial statements. Additionally, quarterly reports and statements are in the 10-Q filing.

Below is an example of where to find total debts and total assets on a balance sheet. You can see that current assets have a total number and a simplified breakdown. Remember, you will also need to add other tangible and intangible assets, both listed here. Additionally, you can see current liabilities such as long-term debt and accounts payable.

Using the Debt-to-Assets Ratio to Invest

Knowing a company’s debt level and how it handles current liabilities can help investors fully understand whether the company can meet future obligations to stay in business. Therefore, it is critical to know how to calculate the debt-to-assets ratio and other solvency ratios before investing in a company.

When used correctly, debt and leverage can allow companies to earn a higher level of profits for a given level of owner’s equity. It’s important to look at the debt-to-assets ratio before investing because some companies use debt to stimulate growth, in which case investors reap high returns if the growth plan is successful. However, in some industries companies may be crippled by too much debt, which could force them to file for bankruptcy. That’s why it’s key to understand the debt-to-assets ratio for each company you plan to invest in. Like we always stress, it’s also crucial to utilize several metrics and ratios to get the full picture, not just a snippet.

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Start analyzing stocks’ solvency ratios like the debt-to-assets ratio to choose suitable investments for your portfolio.