What is a Debt/Asset Ratio?
The debt/asset ratio is a measure of a company's overall financial health. It is determined by dividing the total worth of the assets by the total debt, or liabilities. The number it yields tells investors a number of things.
If the debt/asset ratio number is above one, investors know that more of the company's assets are financed by debt rather than equity. If the number is below one, the opposite is true. If the number is too far above one, that may be a signal to investors the company has too much debt and is not worth the risk, despite what the assets may be.
For example, if Widget Company A had assets of $1.5 million US Dollars (USD), but a debt of $1 million USD, its debt/asset ratio would be 0.66. For many investors this may be an attractive number. However, if Widget Company B has assets of $1 million USD and debt of $1.5 million USD, it has a debt/asset ratio of 1.5.
The lower debt/asset ratio for Widget Company B could make many investors nervous. Therefore, most companies would like to improve that number, if possible. If a company is too far into debt, that could lower its bond rating and mean higher interest rates for any future debt. That may prohibit the company from seeking any future loans at all or, at the very least, lead to a higher cost of doing business.
There are things a company can do to improve its debt/asset ratio, such as a debt-equity swap, an additional stock issue or selling assets to pay down some of the debt. Companies will choose various strategies depending on the circumstances and how much they want to improve that debt/asset ratio number. Some companies may be nearly where they want to be and can handle lowering the ratio with capital already on hand.
Some companies do manage to do well with a higher debt/asset ratio. This could be due to a number of reasons. First, the company may be in an industry that naturally carries as higher ratio as a cost of doing business. Comparing it to its competitors will likely reveal that. Second, it may have completed a large acquisition in the recent past, which could drive those numbers up on a temporary basis. In the end, while the debt/asset ratio is a good guide, it must be considered within the context of the company's specific situation.
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