Debt to asset ratio determines the proportion of external financing used to purchase business assets.
A debt to asset ratio of 0.6x indicates that 60% of the total assets are financed through external debt. It is calculated as:
Debt to asset ratio = Total Debt / Total Assets
Total Debt includes all external liabilities and can be calculated as:
Total Liabilities – Shareholder’s equity
Generally a debt to asset ratio of 0.50 is considered to be prudent. A higher ratio indicates the use of too much leverage and the company may have problems meeting their financial obligations. Companies with a high debt to asset ratio are referred to as ‘highly leveraged’ and are considered to be at a high risk financially. Hence, they may find it difficult to raise further debt or equity to finance any expansion plans.
Debt to Equity
The debt to equity ratio is used by all stakeholders in a company. Including owners, creditors and financial institutions to measure the extent to which the business is reliant on debt financing, or creditor money versus owner’s equity. A debt to equity ratio of 0.70x indicates the debt is 0.7 times the equity and the debt forms 41% of total capital. It is also called a Leverage ratio and is calculates as:
Debt to Equity Ratio = Total Liabilities / Shareholder’s Equity
Debt is considered to be risky since it has interest obligations attached to it along with certain financial constraints. High amounts of debt increase the financial risk of a company since it may not be in a position to pay off debt obligations in the case of declining revenue or a decline in earnings before interest and taxes. A company with a high debt to equity ratio will find it very difficult to raise further capital from the market.