As parents, we're the ones who know best when it comes to managing everyday family finances. But have you ever wondered what's going on behind the scenes when you apply for a loan or credit? Chances are, the lender is reviewing your application package, including your credit history and score. They may also evaluate your creditworthiness using different metrics. For businesses, one of those metrics is the debt-to-asset ratio, and for individuals, the debt-to-income ratio. These financial metrics can help you get a better idea of many things, including whether you'll qualify for credit or need to make some improvements before applying, or if a company is financially healthy enough to invest in.
What is the debt-to-asset ratio?
So, what does debt-to-asset ratio mean?
The debt-to-asset ratio is a calculation that assesses the borrowing risk of a company or person. It compares total existing debts to available assets, resulting in a percentage or ratio. The debt-to-asset ratio helps identify the potential borrower's riskiness and liquidity — or their ability to quickly turn assets into cash. It helps lenders decide whether to approve a loan application.
Generally, borrowers with a higher ratio or percentage — because their debts exceed their assets — are a bigger risk to lenders. If the lender decides to take on this risk, they might charge higher interest rates, require a down payment, or request collateral. If the borrower's application doesn't meet the lender's minimum requirements, they may deny the loan or require a cosigner.
Business lenders usually use debt-to-asset ratios. Consumer lenders, on the other hand, are more likely to consider your debt-to-income ratio when evaluating a credit application. Even so, knowing how to calculate the debt-to-asset ratio can help you in other ways. For instance, you can use it to evaluate the liquidity of a company you're considering investing in. The debt-to-asset ratio tells you whether the company can cover their debts or is financially unstable.
How to calculate the debt-to-asset ratio
Calculating the debt-to-asset ratio is pretty simple. You don't have to be a math whiz to figure out how to do it!
Gather your data
To get started, make a list of a company's obligations and their outstanding balance. This includes all types of debt — auto loans, commercial mortgages 🏤, credit cards, and business loans, for example. Companies categorize these outstanding loans and credit obligations as liabilities on their balance sheets.
Public companies listed on a stock exchange must publish their financial statements, including balance sheets, income statements, and statements of cash flows, every quarter and at the end of the year. Usually, you can find a company's recent financial statements on their website.
Next, find the organization's assets. Assets include anything a company owns and uses to make revenue. They also include anything that can easily be turned into cash. Examples include money in checking and savings accounts, inventory, equipment, property, accounts receivable, and short and long-term investments.
List the current value of the company's assets, just like you did for debts. You can find asset values on the company's balance sheet, listed in the assets category.
Step-by-step process to calculate debt-to-asset ratio
Once you have a complete list of the company's debts and assets, you're ready to calculate the debt-to-asset ratio.
1. Sum up all debts
Using your list, add all debts together. The result is the total outstanding debts the company owes.
2. Add all your assets
Next, sum up all asset values. This will give you the total value of all the company's assets.
3. Apply the debt-to-asset ratio formula
Finally, divide total debts by total assets. The result will be a ratio, such as 0.60. You can convert the ratio into a percentage by multiplying the value by 100 and including the percent sign (in this case, that ratio turns into 60%).
Example of debt-to-asset ratio calculation
Let's calculate the debt-to-asset ratio for a company with a few debts and assets so you can see it in practice.
We'll start with a list of debts:
Debt | Owed Balance |
Credit cards | $5,000 |
Business loan | $10,000 |
Equipment financing | $7,500 |
Long-term loan | $250,000 |
Total: | $272,500 |
Next, let's look at assets:
Asset | Value |
Checking account balance | $1,000 |
Savings account balance | $15,000 |
Inventory | $2,000 |
Investments | $300,000 |
Intangible assets | $150,000 |
Total: | $468,000 |
Using the total debts and total assets, we can calculate the debt-to-asset ratio:
$272,500 total debts / $468,000 total assets = 0.582
To convert the ratio to a percentage, multiply by 100:
0.582 debt-to-asset ratio X 100 = 58.2%
So, we have the number, but what is a good debt-to-asset ratio? The lower the number, the more stable a company or person is. If the debt-to-asset ratio is more than 1, that means the company has more debts than assets and might be a lending risk. If the debt-to-asset ratio is less than 1, the organization has more assets than obligations — a good sign for creditors.
Debt-to-asset ratio versus debt-to-income ratio
While businesses use the debt-to-asset ratio, individuals and families might use a debt-to-income ratio to gauge their financial health 🧑⚕️ instead!
So, why don't we use debt-to-asset ratios for personal finance? In a nutshell, it's because unlike a business, a family probably doesn't sell things they own to earn a living. Sure, having a garage sale for a bit of extra cash is normal, but chances are, that happens once or twice a year. Occasionally, you might resell a big-ticket item you no longer use, like a treadmill collecting dust in your closet. But you probably don't put your furniture on the market weekly or hawk your kitchenware 🥄 to your neighbors. After all, you need those things in your home!
That's different for companies, as they rely on their assets to generate income. They use equipment and machinery to produce products, inventory to entice new buyers, cash to pay suppliers, and investments to get passive earnings. Without assets, a company's business model would be unsustainable.
Both metrics show lenders whether there's enough money for a borrower to cover monthly loan payments. A lender needs assurance that you can pay your bills without hardship. Banks and other financial institutions know your essentials come first — groceries, housing, medicine, and utilities. They expect you to pay for those things before sending your loan payments. So if a lender sees your income is just barely covering your needs, it might hesitate to approve you a loan. There would be a risk you wouldn't be able to make your payments.
The higher your debt-to-income ratio, the more risk a lender accepts if they approve a loan. Some lenders have specific debt-to-income criteria they require before they'll consider a loan. You can ask about their criteria before starting a loan application. If you don't meet their requirements, you can work on reducing your debt-to-income ratio before applying.
What is the debt-to-asset ratio used for?
If a bunch of terms are swimming through your head right now, don't worry! Let's look at some real-life examples of debt-to-income and debt-to-asset ratios so you know when they apply.
Everyday situations
Here are a few everyday situations where you might encounter the debt-to-income ratio.
Homeownership and mortgage repayment
Buying a home is a big milestone, and banks want to see that you can afford future payments before approving your mortgage. Let's say you want to buy a house and need a $350,000 mortgage. The interest rate is 7% on a 30-year mortgage. Your pre-tax monthly income is $8,000, and your estimated monthly mortgage payments are $2,328. You have $1,000 in other outstanding monthly debts to pay.
Because the total of your debts and estimated mortgage is $3,328, and you have $8,000 in monthly income, your debt-to-income ratio is 41.6%. Depending on the bank's policies, that might be acceptable — or you might need to work on lowering outstanding debt or increasing income.
Loans and credit cards
If you haven't already applied for a loan or credit card, you — or your teen — probably will one day. These financial tools can help you build credit and buy things you need. During the application process, the bank or lender will review your current debt balances and income to determine whether you can take on more debt and meet payment obligations. A healthy debt-to-income ratio helps make the application process smooth and fast.
Student loan repayments
Let's say you want to go back to college and get your master's degree 🎓 and you need a student loan to help pay for your tuition and books. Your lender will check your debt-to-income ratio to check your ability to make each monthly payment.
How lenders use the debt-to-asset ratio
Like consumer lenders, financial institutions look at the debt-to-asset ratio when deciding whether to extend credit to a business.
Business loans and credit cards
Companies also turn to loans and credit cards for different goals, such as supporting cash flow needs or paying for unexpected expenses. Before approving a business loan or credit card, the lender will evaluate the company's debt-to-asset ratio and liquidity. A company with too much debt relative to expenses might find it harder to get a loan.
Equipment and machinery financing
Businesses purchase equipment and machinery to support office functions, create products, and provide services. A company that wants to finance equipment instead of buying outright will apply for a loan or equipment lease. The lender will check the potential borrower's debt-to-asset ratio to see if they can afford regular debt payments.
Elevate your financial knowledge with Greenlight
Now that you know how debt impacts a lender's loan approval process, you're well on your way to exploring ways to build credit, minimize debts, and improve your family's finances.
As you continue on this path, plug into Greenlight's Learning Center, made for parents, kids, and families. It has hundreds of articles that make complex financial concepts seem easy. You can also check out our investing app, which shows kids and teens basic concepts of building wealth. Get started with Greenlight today and get one month, on us!
