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 metric enables comparisons of leverage to be made across different companies.
The higher the ratio, the higher the degree of leverage (DoL) and, consequently, financial risk. The total debt to total assets is a broad ratio that analyzes a company's balance sheet by including long-term and short-term debt (borrowings maturing within one year), as well as all assets—both tangible and intangible, such as goodwill.
The Formula for Total Debt to Total Assets Is
TD/TA=Total AssetsShort-Term Debt+Long-Term Debt
Total Debt to Total Assets
What Does Total-Debt-to-Total-Assets Tell You?
Total-debt-to-total-assets is a measure of the company's assets that are financed by debt, rather than equity. This leverage ratio shows how a company has grown and acquired its assets over time. Investors use the ratio not only to evaluate whether the company has enough funds to meet its current debt obligations but also to assess whether the company can pay a return on their investment.
Creditors use the ratio to see how much debt the company already has and whether the company has the ability to repay its existing debt, which will determine whether additional loans will be extended to the firm.
- The total debt to total assets ratio shows the degree to which a company has used debt to finance its assets.
- The calculation considers all of the company's debt, not just loans and bonds payable, and considers all assets, including intangibles.
- If a company has a total debt to total assets ratio of 0.4, this shows that 40% of its assets are financed by creditors, with owners (shareholders) financing the remaining 60% with equity.
Example of How to Use the Total-Debt-to-Total-Assets Ratio
Let's examine the total debt to total assets ratio for three companies—The Walt Disney Company, Chipotle Mexican Grill, Inc., and Sears Holdings Corporation—for the fiscal year ended 2017 (December 31, 2016, for Chipotle).
|(data in millions)||Disney||Chipotle||Sears|
|Total Debt to Assets||0.5302||0.3078||1.4085|
A ratio greater than 1 shows that a considerable portion of the debt is funded by assets. In other words, the company has more liabilities than assets. A high ratio also indicates that a company may be putting itself at risk of defaulting on its loans if interest rates were to rise suddenly. A ratio below 1 translates to the fact that a greater portion of a company's assets is funded by equity.
From the example above, Sears has a much higher degree of leverage than Disney and Chipotle and therefore, a lower degree of financial flexibility. With more than $13 billion in total debt, it's easy to understand why Sears was forced to declare Chapter 11 bankruptcy in October 2018. Investors and creditors consider Sears a risky company to invest in and loan to due to its very high leverage.
Debt servicing payments have to be made under all circumstances. Otherwise, the company would breach its 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.
A company with a high degree of leverage may thus find it more difficult to stay afloat during a recession than one with low leverage. It should be noted that total debt measure does not include short-term liabilities such as accounts payable and long-term liabilities such as capital lease and pension plan obligations.
Limitation of the Total-Debt-to-Total-Assets Ratio
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. For example, assume from the example above that Disney took on $50.8 billion of long-term debt to acquire a competitor and booked $20 billion as a goodwill intangible asset for this acquisition.
Say the acquisition does not perform as expected and results in the entire goodwill asset being written off. In this case, the ratio of total debt to total assets (which would now be $95.8 billion - $20 billion = $75.8 billion) would be 0.67.
Like all other ratios, the trend of the total debt to total assets ratio should also be evaluated over time. This will help assess whether the company’s financial risk profile is improving or deteriorating. For example, an increasing trend indicates that a business is unwilling or unable to pay down its debt, which could indicate a default at some point in the future.