The total debt / total assets ratio measures how leveraged a company is, meaning that what percentage of its assets is financed with debt. This accounting ratio is calculated by dividing the total debt of the company by the total assets. For example, if XYZ Corporation has $ 50 million in short-term and long-term debts and $ 100 million in total assets, the total debt to total assets ratio is 0. 5. In this scenario, XYZ Corporation is 50% leveraged; half of its assets are debt-financed.
This ratio is a valuable tool for investors and creditors because it gives an indication of how much financial risk a company entails. A company with a high leverage is more risky because, if a recession or a slow economic cycle lags behind payments of debts, the creditors can force it to file for bankruptcy and liquidate assets.
The reason why the relationship between total debt and total assets is represented as a ratio instead of subtracting assets from debts is because the latter approach does not offer standardization based on company size. For example, suppose Company A has $ 20 million in assets and $ 4 million in debt, while Company B has $ 250 million in assets and $ 200 million in debt. After deducting debts, company A is left with only $ 16 million in assets, while company B has a hefty $ 50 million. Because of this calculation, company B is represented as the least risky and more stable company. After all, it owns much more free and clear assets in terms of pure dollar amount.
The ratio of total debt to total assets, however, tells the real story. Company B has 80% of its assets in debt, while that number is only 20% for company A. Company B has been used much better; its greater debt with regard to its assets means that it presents a higher default risk if the economic winds turn against it.