Ratio of Indebtedness Ratio of Total Assets – Definition

 

The ratio of indebtedness ratio of total assets, serves to establish a metric of the degree of indebtedness of a company in relation to the total of its assets.

When financing their activity, companies can choose two ways. Either they finance their activity with their own funds, or they are financed through their creditors.

Its calculation formula is the following:

Each company has to find its optimal capital structure based on their needs and market conditions at all times. The debt ratio of the total assets will allow us to know what proportion of the activity of the company (total assets) is financed by its creditors (total liabilities).

 

Optimal values ​​of the ratio of indebtedness ratio of total assets

 

Optimal values ​​of the ratio of indebtedness ratio of total assets

As usual, the optimal values ​​of the ratios always depend on the sector and the casuistry of each company. However, values ​​between 40% and 60% are considered adequate.

If the value exceeds 60%, the company would be leaving a large part of its financing to third parties. This could cause him to lose autonomy in his administration and management and generate a great interest load. On the other hand, if the ratio is below 40%, the company would have a very high level of equity.

 

Calculation example

 

Calculation example

 

Suppose that company A has a total asset of 100 and total liabilities of 50. On the other hand company B has a total asset of 100 and total liabilities of 75. If we calculate both ratios we have the following:

Debt ratio for the company A = 50/100 = 0.5
Debt ratio for the company B = 75/100 = 0.75

If we multiply the previous examples by 100, we see that company A finances 50% of its activity with third parties and the other 50% with own funds. In this way the company would have a capital structure within the appropriate parameters.

However, the company B is financing 75% of its activity with outside resources and only 25% with its own funds.

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Importance of an optimal capital structure

 

Importance of an optimal capital structure

 

Based on the capital structure of each company, the economic situation could affect them to a greater or lesser extent. Below are some examples.

Changes in interest rates can be a big headache for companies. If a company has a live debt issue at 2% and the interest rate drops to 1%, the company would be paying 1% more on the outstanding balance of its debt. If the company had cash available, it could repurchase that debt and reissue 1% debt. Otherwise, the company would be paying more interest than it could pay for market conditions. This would ballast your results.

Another problem could come for years with poor results. If there are years with poor results, companies can reduce the dividend and even eliminate it. But the payment of debts can not be reduced or suspended.

Therefore, based on the examples of company A and company B, the latter would be considerably more affected by the aforementioned changes since a greater part of its activity is financed by third parties.

 

 

 

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