Debt to Asset Ratio

The debt to assets ratio is an indicator of the proportion of a company’s assets that are being financed with debt, rather than equity. A ratio greater than 1 indicates that a considerable proportion of assets is being funded with debt, while a low ratio indicates otherwise.

What are the implications when a ratio is greater than 1?

The company may encounter difficulty in servicing its debt. This is all the more likely if the company’s main business is of a cyclical nature, for example a property developer. Should demand for properties drop, the company’s cash flow could be severely affected causing it to face debt-servicing problems.

A company that takes variable-rate loans may also be at risk as interest rate fluctuations may lead to sudden increases in repayment amounts.

This is the formula for the calculation of Debt to Asset ratio:

Total Debt
Total Asset

Let’s take a look at the following example:

Company

Total Debt

Total Asset

Debt to Asset ratio

A

RM50 million

RM100 million

0.5

B

RM150 million

RM100 million

1.5

Assuming both A and B are in the same sector, Company A’s debt to asset ratio of 0.5 is more attractive to an investor. It would appear that the management of Company A is more prudent and efficient in steering the company – being able to manage its finances wisely compared to B.

Debt servicing payments must be made under all circumstances otherwise the company may run into other unsavoury risks such as being forced into bankruptcy by creditors.

Thus, looking at the different ratios of A and B, investors may want to put their money into A instead of B.

On another note, the trend of the ratio for a particular company needs to be evaluated as well. For example, has the ratio improved or worsened over the years? This would be an assessment of the company’s financial risk profile – improving or deteriorating.

Data for Total Assets and Total Debt/Liabilities are easily obtained from the RHBInvest and OSK188 online trading portals.

 

Source:
http://www.investopedia.com/terms/t/totaldebttototalassets.asp accessed on 15 October 2014
http://www.accountingtools.com/debt-to-assets-ratio accessed on 15 October 2014