What is 'Total Debt To Total Assets'
Total debt to total assets is a leverage ratio that defines the total amount of debt relative to assets. This enables comparisons of leverage to be made across different companies. The higher the ratio, the higher the degree of leverage, and consequently, financial risk. This is a broad ratio that includes long-term and short-term debt (borrowings maturing within one year), as well as all assets – tangible and intangible.
BREAKING DOWN 'Total Debt To Total Assets'
For example, assume hypothetical company Levered Co. has $40 million in long-term debt, $10 million in short-term debt, and $100 million in total assets. Levered Co. would therefore have a total debt to total assets ratio of 0.5. On the other hand, if rival LowLevered Co. has $5 million in long-term debt, $5 million in short-term debt, and $50 million in total assets, its total debt to total assets ratio would be 0.2.
From the above example, 50% of Levered Co.’s assets have been financed by debt, while only 20% of LowLevered Co.’s assets were. Levered Co. has a much higher degree of leverage than LowLevered Co., and therefore a lower degree of financial flexibility.
This is because debt servicing payments have to be made under all circumstances, otherwise the company would breach debt covenants and run the risk of being forced into bankruptcy by creditors. While other liabilities such as accounts payable and long-term leases can be negotiated to some extent, there is very little “wiggle room” with debt covenants. Therefore, a company with a high degree of leverage may find it more difficult during a recession than one with low leverage. It should be noted that total debt measure does not include short-term liabilities like accounts payable and long-term liabilities such as capital lease and pension plan obligations.
One shortcoming of the total debt to total assets ratio is that it does not provide any indication of asset quality, since it lumps all tangible and intangible assets together. Continuing from the above example, assume Levered Co. took on the $40 million of long-term debt to acquire a competitor, and booked $20 million as goodwill for this acquisition. Let’s say the acquisition does not perform as expected and results in all the goodwill being written off. In this case, the ratio of total debt to total assets (which amounts to $80 million) would be 0.63.
Like all other ratios, the trend of the total debt to total assets should also be evaluated over time. This will help assess whether the company’s financial risk profile is improving or deteriorating.