The extent of leverage within a company is determined by taking into account the debt to asset ratio. This is a ratio which makes it easy and effortless to compare and contrast the leverage amongst different business organizations. In ratio analysis, debt to asset ratio plays a very important role and the concerns of this article will clarify how you may analyze such a ratio and use it for making vital financial decisions.
Debt to asset ratio – What is it?
Debt to asset ratio is a solvency ratio which determines the total liabilities of a business organization as a percentage of the assets owned by the same. The calculation process is simple as it divides the total liabilities or debt by total assets. This ratio has the goal of measuring the capability of a company to repay its assets with the help of its assets. To express this in terms of a layman, this ratio determines the number of assets that need to be sold off in order to repay the debt owed by a company. This can also be said to be measuring the fiscal leverage of a company.
Why is it important to enhance your debt to asset ratio?
A high level of debt to asset ratio is pretty bad for a company and hence it is important for the business owner to take steps to lower this ratio. But what are the reasons behind this?
- A high debt to asset ratio implies that a larger percentage of assets can be financed through debt. This is a clear indicator that the creditors have more claim on the assets of the company.
- Higher debt to asset ratio boosts the difficulty of obtaining loans for financing new projects as the lenders will deem you to be a risky borrower.
- A higher debt to asset ratio also multiplies the risk of insolvency. In case the company is liquidated, it may not be able to repay all the liabilities with its assets.
Hence, don’t you think it is vital for a company to lower its debt to asset ratio? But how can they lower it?
How to improve your company’s debt to asset ratio?
Here’s how a company can lower the debt to asset ratio and increase chances of being considered as a creditworthy borrower.
- Issue of new stock: The company can instantly issue shares to boost the cash flow and thereafter use the proceeds to repay the remaining liabilities and reduce debt burden.
- Equity and debt swap: By implementing a debt or equity swap, you can make an equity shareholder in the company and this in turn will cancel the debt that you owe him.
- Boost sales: The company may focus largely on increasing sales but without any increase in overhead expenses.
Debt to asset ratio is a vital solvency ratio and all companies should keep monitoring this ratio as creditors always keep a close watch on this number. Follow the above listed steps to lower your debt to asset ratio and be considered a trustworthy company by all lenders.