The company’s value is mainly stored either in equity or debt. Understanding just how much of it is owned by creditors is important because if they own a sizable portion of the company, then investing in it is very risky.
The debt-to-asset ratio estimates precisely that – a portion of the company’s value owned by creditors as opposed to stockholders. This ratio is usually represented by leverage, with debt on one side and asset value on the other. Divide total debt by total asset value, and you’ll get a number that reflects the leverage size.
Explaining D2A ratio
The ratio represents the percentage of the business’ value occupied by the total debt it owes (in all forms), as opposed to the total assets that more or less belong to it. This gives you a rough idea of how well the company’s doing, how it accumulated its wealth, and whether you should invest in it.
The total debt mostly consists of several parts:
- Monetary loans
- Bonds payable
- Accounts payable
- Borrowed property.
This includes both long-term debts and short-term debts.
Basically, if the assets are not owned by the company or anyone associated with it, then it’ll likely go to the total debt category. What you’ll want to do then is compare it to the total value of all assets (tangible & non-tangible). This will give you a number that should tell you just how much of the business is run on credit.
Estimating the ratio
The formula goes like this:
D2A = Total Debt Size/Total Assets Value
You can represent it as a percentage, but most people just take the number directly. If the number is 0.4, then 40% of the company’s value is owned by creditors, while the remaining 60% is their own property. This is generally how most people assess the debt ratio, although you might not even need to do it.
This information is supposed to be general knowledge, so you can easily find it online. Since many big companies leave their monthly Balance sheets in open access, they are quickly processed by the experts to present tons of useful information, with debt ratio being part of it.
Understanding the ratio
Although you likely need some semblance of expertise to make the most out of this information, you can be a beginner investor and still understand what the ratio implies right away.
You don’t need to be a genius to realize that companies with more debt than assets aren’t doing very well. They are likely going to fail eventually, although financial instability is bound to speed up the process. If the market enters recess, the creditors will usually increase the interest, but they can also demand the payment in full.
In these instances, the company will have to use its own capital to pay back. If the ratio is greater than 1, then it’s not going to be enough, and it’ll likely go bankrupt. Alternatively, if the ratio is smaller than 1, then it may still cripple it, even though it’ll survive the fall.
That’s generally why all of the company’s assets are accounted for, including non-tangible property if it has any value. That’s, however, where the issues with this ratio arise. This ratio, in its purest form, doesn’t account for anything else except the pure monetary value of the assets.
The ratio doesn’t take into account the disparity of assets’ efficiencies. That’s why it’s not totally accurate when assessing the company’s financial health.
What is it used for?
It’s mostly used to determine whether the company is doing well or not. Apart from the usual investing risk assessment, it’s used for credit risk assessment (for creditors to determine whether it’s worth lending them money or not) and trends evaluation. In this sense, it’s often a comparative factor.
The ratios of companies are compared among one another to see which of them is more trustworthy. At the same time, the ratios from the same company but from different periods are compared to see what sort of progress the company has made over time.
If the debt has increased, then you can research more and see why their debt keeps increasing and whether the assets do too. If not, then it means that the company’s growth is exclusively due to the borrowed funds and not for their own merits. The potential is limitless, really.