Companies often prefer to acquire new assets with their cash flow rather than by raising capital, but that’s not always possible. In these cases, companies raise capital through debt or equity. Both have costs associated with them in the form of cost of debt and cost of equity. Companies often use debt to acquire assets, but it’s considered risky when a company is overleveraged.
The lowest possible debt to asset ratio is always preferred. A debt ratio of significantly less than 1 is considered good. It indicates that the company uses only adequate leverage to acquire assets. You can assume that the company acquired its assets through its cash flows or by raising equity.
A debt to asset ratio closer to 1 indicates a highly leveraged company. It shows that the company acquired the majority of its assets through debt. It’s risky to have such a high amount of debt.
A debt to asset ratio higher than 1 indicates that the company took on more debt than the value of its assets. It’s possible that the assets the company acquired haven’t delivered a return and were written off. However, the company still must service the liability it took on to acquire the asset. When the debt ratio is very high, the total liability is often more than the cash flow gained from existing assets. This is highly risky, and such debt to asset ratios are common for companies on the brink of bankruptcy.
The debt to asset ratio varies for different industries and business models. For example, the real estate industry uses leverage to fund most of its projects. Real estate companies typically have a very high debt to asset ratio, but this doesn’t necessarily mean that it’s a bad business. It’s better to compare the debt ratio of companies operating within the same industry with the same set of constraints.
One drawback with the use of debt ratio is that it bundles all the different types of assets into one basket. There is no mechanism to distinguish the quality of the assets acquired by leverage.
The debt to asset ratio is often checked by loan officers to decide whether to write a new loan or not. Having a high debt ratio is considered to be financially risky. Investors also can use the debt ratio as a metric to gauge the risk associated with investing in a particular company.
