Whether you own a business or want to make smarter money moves, your debt-to-asset ratio plays a key role in determining your eligibility to borrow money.
In this article we will discuss how to calculate your ratio, identify a favorable ratio, and what lenders examine in your financial records. You’ll discover ways to improve your score and learn about the mistakes others often make.
What Is the Debt to Asset Ratio?
Your debt-to-asset ratio is an indicator of your financial health. It illustrates the proportion of your assets that are financed by debt. It reveals how much you own versus how much you owe.
It’s a simple comparison: take everything you own (your assets) and measure it against everything you owe (your debts). For instance, purchasing a house with a mortgage means you owe money to the bank while simultaneously owning a property.
Meanwhile, when you apply for a loan, lenders consider this ratio to decide if you’re likely to pay it back or not. This concept is applicable to both business and personal financial management.
“Explain it to me like I’m 5”
Let’s say Jeff, an unemployed acquaintance, asks to borrow $10. Before deciding, you’d naturally wonder:
“Do I trust Jeff?”
“Will Jeff pay me back?”
Then you learn from Mary that Jeff already borrowed $100 last week and hasn’t paid her back. Suddenly, your decision is easy – that $10 stays in your pocket.
This is exactly how the debt-to-asset ratio works in real life. Banks use it to see if someone owes too much compared to what they own, helping them decide if lending money is a smart move.
Why the debt-to-asset ratio matters
The debt-to-asset ratio is crucial for three main groups in the financial world.
- Businesses rely on it to monitor their financial health and ensure they’re not taking on excessive debt that could put them at risk.
- Lenders use this ratio when reviewing loan applications, helping them assess if borrowers can realistically handle additional debt.
- Investors carefully analyze this number to determine if a company is financially stable enough to be worth their money.
In simple terms, it’s a vital health check that helps everyone make smarter financial decisions.
Why is a Good Debt to Asset Ratio Important
A good debt-to-asset ratio opens doors for your financial future. Lenders look at this number first when deciding whether to approve your loans and what interest rates to charge you.
Think of it as your financial report card – a good ratio shows lenders and investors that you’re handling your money responsibly and have enough assets to back up your debts. A strong ratio can lead to better loan terms and lower interest rates, potentially saving you thousands over time.
It also gives you more flexibility when you need to borrow money for major purchases or business expansion.
What makes a “good” debt-to-asset ratio
A common benchmark for a good debt-to-asset ratio is 30% (or 0.3), according to Michigan State University professor Adam Kantrovich. Going above this threshold can limit your ability to borrow more money when needed.
However, what counts as “good” varies across different industries. Real data from CSI Market shows just how wide this range can be. Internet and social media companies typically maintain ratios around 41%, which aligns fairly close to the general benchmark.
On the other hand, retail businesses often run much higher ratios, averaging around 249%. This higher ratio makes sense given their need to invest heavily in inventory and physical infrastructure before they can start generating revenue.
Understanding risk levels
The higher your debt-to-asset ratio climbs, the more financial risk you take on. When you’re carrying more debt, opening new credit lines becomes riskier and could make it harder to get funding when you really need it.
However, some industries naturally operate with higher ratios due to their business model. Production and retail businesses often need substantial upfront investments just to get started. These sectors typically carry higher ratios, and lenders understand this industry-specific context.
Take utilities companies, for instance – they average an impressive 283% ratio, while technology companies typically maintain ratios around 100%. These higher numbers reflect the substantial infrastructure and equipment investments these industries require, rather than poor financial management.
Impact on business growth
Your debt-to-asset ratio can be a make-or-break factor in your financial journey. It could determine whether lenders open their doors to you or shut them in your face when you need funding most.
Let’s look at some real-world examples:
Consider a small business owner with:
- $25,000 in debt
- $100,000 in assets
- Resulting ratio: 25%
This ratio would be considered healthy for internet services and exceptional for retail businesses.
Now flip those numbers:
- $100,000 in debt
- $25,000 in assets
- Resulting ratio: 400%
This scenario raises red flags regardless of your industry. Such a high ratio suggests financial strain and would likely make most lenders extremely hesitant to extend additional credit.
While different industries have different standards, extremely high ratios like 400% are concerning to lenders and can limit your business growth opportunities.
How to Calculate the Debt to Asset Ratio
You can use the formula below to calculate your deb-to-asset ratio:
The basic formula
Like your credit score, your debt-to-asset ratio is a key financial number. It reveals how much of your assets (cash, investments, inventory, etc.) were purchased using borrowed money.
Calculating your debt-to-asset ratio is simple: Take the debt you owe and divide it by the value of the assets you own. Then, take that number and multiply it by 100 so you get a percentage. That’s your debt-to-asset ratio.
It’ll look something like this:
Dollar amount of debt you owe ÷ Dollar amount of assets you own =
Debt-to-asset ratio
And then:
Debt-to-asset ratio x 100 = Debt-to-asset ratio percentage
This simple calculation gives you a clear picture of your financial leverage and helps you understand your position when seeking additional funding.
What counts as debts and assets
Your total debt includes all money you owe through various channels, including credit cards, bank loans, student loans, mortgages, car loans, business loans, unpaid bills, and any other instances where you owe money to someone.
Your assets encompass everything you own that has value. This means your cash and savings, investments and securities, stocks and bonds, inventory, equipment, real estate, vehicles, property, valuable collectibles, and anything else that could potentially be converted to cash if needed.
When calculating your ratio, make sure to account for everything in both categories to get an accurate picture of your financial position. Use current market values for your assets rather than their original purchase prices.
Real-world calculation of debt-to-asset ratio
Let’s break down a realistic business scenario with specific numbers to show exactly how this works.
Here’s what our example business owes (Total Debts):
The business has a bank loan of $15,000, outstanding credit card debt of $5,000, and equipment financing of $5,000. When we add all these debts together, the total debt comes to $25,000. This represents all the money this business has borrowed and needs to pay back.
Here’s what our example business owns (Total Assets):
Cash in accounts totaling $20,000, equipment valued at $50,000, and inventory worth $30,000. When we add these together, the total assets come to $100,000. This represents everything of value the business owns that could potentially be sold or liquidated if needed.
Now let’s calculate:
$25,000 (total debt) ÷ $100,000 (total assets) = 0.25
Convert to percentage:
0.25 x 100 = 25%
This 25% debt-to-asset ratio means that for every dollar of assets the business owns, 25 cents was financed through debt. In other words, the business owns 75% of its assets free and clear, with only 25% being financed through loans or credit. This would be considered healthy for most industries, as it shows the business isn’t overly reliant on debt to finance its operations.
What does your ratio mean?
A lower ratio like 25% suggests you have a good balance between debt and assets, with most of your assets being funded by equity rather than debt. This makes you an attractive prospect for lenders since it shows you’re managing your finances well and aren’t overly reliant on borrowing.
A higher ratio, such as 70% or above, indicates that most of your assets are financed through debt. This could make lenders hesitant to extend additional credit, and if they do, you might face higher interest rates. It suggests you’re heavily dependent on borrowed money to operate, which presents a higher risk to potential lenders.
The ideal ratio varies by industry, but generally, lower is better. A lower ratio gives you more flexibility to borrow if needed and shows you’re maintaining a sustainable balance between what you own and what you owe.
Other Ratios That Are Good to Know
Here are some other rations that are good to know:
Debt-to-equity ratio for businesses
Sometimes, lenders look at a business’s debt-to-equity ratio instead. While this mainly applies to larger corporations with shareholders, understanding how it works is valuable.
The debt-to-equity ratio compares a company’s debt to shareholder equity (the value of the shares).
It’s calculated similarly to the debt-to-asset ratio:
Dollar amount of debt you owe ÷ Dollar amount of shareholder equity = Debt-to-equity ratio
Then multiply by 100 to get the percentage.
For example, if a company has:
Total debt: $200,000
Shareholder equity: $100,000
The calculation would be:
$200,000 ÷ $100,000 = 2
2 x 100 = 200%
Like the debt-to-asset ratio, what’s considered “good” varies by industry, but generally, it should be no higher than 2 (or 200%). A ratio above this suggests the company is taking on too much debt relative to its equity.
Debt-to-income ratio for individuals
Your debt-to-income ratio is crucial when applying for a mortgage – it compares your gross monthly income to your monthly debt payments.
The calculation:
Dollar amount of monthly debt you owe ÷ Dollar amount of your gross monthly income = Debt-to-income ratio
Then multiply by 100 for the percentage.
Let’s look at a real example:
Monthly debt payments: $1,000
Annual income: $75,000 (which is $6,250 per month)
Calculate:
$1,000 ÷ $6,250 = 0.16
0.16 × 100 = 16%
This 16% debt-to-income ratio would be considered excellent by most lenders, as:
- Ideal ratio is 35% or below
- Most lenders will approve mortgages for ratios up to 43-45%
- Your 16% ratio shows you have plenty of monthly income available to take on a mortgage payment
This low ratio suggests you’re managing your debt well and have significant room in your budget for a mortgage payment.
How to Improve Your Debt-to-Asset Ratio
Here are a few ways to improve your debt-to-asset ratio:
Reduce debt
One of the most direct ways to improve your debt-to-asset ratio is to create an aggressive debt payoff plan that prioritizes high-interest loans first. These debts typically cost you the most money over time and have the biggest impact on your ratio. For instance, focusing on paying off a credit card with 20% APR before tackling a car loan at 5% APR will save you more money in the long run.
For businesses specifically, improving operational efficiency can free up cash flow that can be redirected toward debt reduction. This might include negotiating better terms with suppliers, reducing unnecessary expenses, or streamlining processes to reduce overhead costs.
If you can save $500 monthly by renegotiating supplier contracts and reducing overhead, that’s $6,000 annually you could apply to debt reduction. This both reduces your debt and improves cash flow, creating a positive cycle for your financial ratios.
Increase asset value
Strategic investments in assets that appreciate over time can help improve your ratio. For businesses, this might mean investing in new equipment that increases productivity or purchasing real estate that will likely appreciate in value. These investments, when chosen carefully, can provide both immediate operational benefits and long-term value growth.
Another effective strategy for businesses is to improve inventory management by implementing just-in-time systems that reduce excess inventory while maintaining optimal stock levels. This effectively increases the value of current assets without increasing debt.
For example, rather than storing three months of inventory, a business might maintain just two weeks’ worth, freeing up capital that would otherwise be tied up in excess stock. This approach not only improves the asset side of your ratio but also reduces storage costs and minimizes the risk of inventory becoming obsolete.
These strategies work together to strengthen your financial position by making your assets work harder for you while keeping debt levels in check. The key is selecting investments that offer real value growth potential rather than simply acquiring assets for the sake of expansion.
Maintaining long-term balance
The key to maintaining a healthy debt-to-asset ratio over time is to create clear policies about when and how to take on new debt. For example, only taking on new debt when it directly contributes to increasing revenue or when the return on investment clearly exceeds the cost of borrowing.
If a new loan at 6% interest will fund equipment that generates a 15% return, that’s a sensible use of debt. However, taking on debt for non-essential purchases or expenses that don’t generate returns should be avoided.
It’s crucial to monitor your ratio regularly and make adjustments before problems arise. This means setting up monthly or quarterly reviews of your debt levels and asset values and having predefined thresholds that trigger action plans when your ratio starts trending in the wrong direction.
For instance, if your ratio increases by more than 10% in a quarter, this could trigger a review of recent debt acquisitions and asset performance, allowing you to address issues while they’re still manageable rather than waiting for them to become critical problems.
Regular monitoring and clear policies help maintain financial stability and ensure your debt remains at sustainable levels relative to your assets.
Common Mistakes When Using the Debt-to-Asset Ratio
Watch out for these common mistakes when using the debt-to-asset ratio:
Overlooking asset quality
A mistake when calculating your debt-to-asset ratio is treating all assets as equal. For example, $100,000 in easily accessible cash is very different from $100,000 in specialized equipment that might be difficult to sell quickly if you need to cover debts. Cash and highly liquid investments provide immediate financial flexibility, while specialized machinery or custom inventory might take months to convert to cash, and often at a significant discount from their book value.
Many businesses fail to consider the depreciation of their assets when calculating their ratio–that new $50,000 piece of equipment might only be worth $25,000 in resale value, which means your actual debt-to-asset ratio could be much higher than you think.
This oversight can create a false sense of financial security. A manufacturing company might show $2 million in assets on paper, but if half of those assets are aging equipment with limited resale value, their effective ratio could be twice as high as their calculations suggest.
Ignoring industry benchmarks
One of the biggest mistakes businesses make is comparing their debt-to-asset ratio to an arbitrary “good” number rather than their specific industry standards–remember, while internet service companies average around 25%, retail businesses commonly operate at 289% due to their business model.
This significant difference reflects the different capital requirements and operational structures between industries. Internet companies often have minimal physical assets and can scale quickly with relatively little debt, while retailers need substantial inventory and physical locations that require significant financing.
Your debt-to-asset ratio needs to be evaluated within your industry’s typical needs for upfront capital and ongoing operational costs. What’s considered a dangerous ratio in one industry might be perfectly normal in another.
A manufacturing company with heavy equipment investments might comfortably operate with a higher ratio than a consulting firm that primarily relies on human capital. A ratio that would set off alarm bells in the software industry might be completely sustainable in real estate development, where high leverage is common and often necessary for growth.
Relying solely on a single metric
Checking only your debt-to-asset ratio is like diagnosing health with just a temperature reading. True financial health requires a broader view.
Start with your debt-to-income ratio to understand if you can comfortably make debt payments. Then examine your debt-to-equity ratio to see the balance between borrowed money and business ownership. Your current ratio reveals whether you can handle short-term obligations, while cash flow metrics show your ability to generate money for debt payments.
Together, these numbers tell your complete financial story. They show not just what you owe, but your ability to handle and pay those debts. Monitor them regularly, compare them to your industry standards, and watch for concerning trends before they become problems.
This approach can help you spot potential issues early and make better financial decisions for your business.
Not considering timing and context
Calculating your ratio at a single point can be misleading, especially for seasonal businesses. A retail store’s ratio might look concerning in November when inventory is high for holiday sales, but healthy in February during regular operations. This fluctuation is normal and should be factored into any financial analysis.
Looking ahead is equally important. Your current ratio might be acceptable, but if you’re planning to purchase new equipment or expect a large contract payment, your financial picture could change dramatically. For example, a construction company might show a high ratio while building up resources for a major project, knowing they’ll have substantial incoming payments once the project completes.
Smart financial management means understanding both the seasonal patterns of your business and planning for future changes that will affect your ratios. Regular monitoring throughout the year provides a more accurate picture than a single snapshot in time.
