A company with too much debt can be a ticking time bomb. When you review a company’s finances, you can use the debt-to-total assets ratio to analyze its debt level and to compare its risk to other companies. This ratio measures a company’s debt as a percentage of its total assets. Using the ratio won’t guarantee a successful investment, but it might help you avoid a deteriorating company.
The debt-to-total assets ratio equals total liabilities divided by total assets, times 100. A company reports total liabilities and total assets on its balance sheet. Say a company has $35,000 in total liabilities and $100,000 in total assets. Its debt-to-total assets ratio would be 35 percent: $35,000 divided by $100,000, times 100. This means that the company finances 35 percent of its assets with debt, which is a fairly conservative number.
A higher debt-to-total assets ratio suggests that a company has a higher chance of insolvency, or the inability to pay its debts, than a lower ratio. Some debt can be good for a company and can help it generate more earnings. If a company has too much debt, it must make big interest payments, which can eat into its profits and cash. For example, a 35 percent debt-to-total assets ratio might help boost a company’s profits, while a 95 percent ratio might drive a company into bankruptcy.
Comparing the Ratio
You can compare a company’s debt-to-total assets ratio over different periods and with the industry average to determine an acceptable debt level. A company’s debt-to-total assets ratio should be in the same ballpark as the industry average and should refrain from rising too much over time. An increasing ratio that skyrockets above the industry average could be a red flag. For example, if a company’s debt-to-total assets ratio grows from 50 percent to 90 percent when the industry average is 55 percent, the company might be on thin ice.
A single financial ratio can tell you only so much about a company’s financial health. A company might have a low debt-to-total assets ratio, but might be weak in other areas of its business. You should use a debt-to-total assets ratio with other ratios and information when assessing a company’s finances. Also, a company reports some asset values at their original cost on its balance sheet. The market values of its assets might change, which can distort the true risk of its debt level.