What is the Long Term Debt to Assets Ratio?
The Long-Term Debt to Asset Ratio is a metric of debt financial ratio that tracks the portion of a company’s total assets that is what percentage of the total assets is financed via long-term debt.
This ratio allows analysts and investors to understand how leveraged a company is for us.
This ratio provides a sense of financial stability and overall riskiness of a company. Investors are wary of a high ratio, as it signifies management has less free cash flow and less ability to finance new operations.
Management characteristically utilizes this financial ratio to resolve the amount of debt the company may sustain and supervise the overall capital structure of the company.
The more leveraged a company the more sensitive. It will be to potential market and sales downturns that negatively affect its capacity to fulfil its financial commitments.
This provides a clear representation of how leveraged a business is, by analyzing the percentage of its assets that are presently funded through debt.
If the business is increasingly increasing its Long Term Debt to Assets ratio, its growth model or tactic may be categorized as too risky or untenable over time.
Advantage of Long-Term Debt to Asset Ratio
- The long-term debt-to-total-assets ratio is a coverage or solvency ratio used to calculate the amount of a company’s leverage.
- Important for investors to assess business potential risks.
- The ratio result shows the percentage of a company’s assets it would have to liquidate to repay its long-term debt.
- This ratio provides a clear picture of how leveraged a business is.
- Recalculating the ratio over several time periods can reveal trends in a company’s choice to finance assets with debt instead of equity and its ability to repay its debt over time.
- It’s also important to look at off-balance sheet items like operating lease and pension obligations.
Disadvantage of Long-Term Debt to Asset Ratio
- Its growth model or tactic may be categorized as too risky or untenable over time.
- The more leveraged a company the more sensitive.
Long-Term Debt to Asset Ratio Formula
The formulation is as follows:
Long Term Debt t Asset Ratio = LTD / A = Long Term Liabilities / Total Assets
Long Term Liabilities: The sum of all debts that have a maturity date or due date beyond the next 12 months.
Total Assets: The sum of all current assets, other assets and fixed assets.
The ratio can be expressed either in decimals or as a percentage.
Long Term Debt to Asset Example
Santosh Electronics is a business that manufactures household appliances and electronic devices. The company is publicly traded and currently it has a market capitalization of $6,430,000,000. Recently the business has been expanding itself and as part of this effort it sold a $2,225,000,000 bond issue to finance its growth.
Analysts are worried about this move as they suspect the business may be increasing its leverage significantly. The company’s Balance Sheet shows the following information:
- Current Assets – $2,504,000,000
- Fixed Assets – $5,431,000,000
- Other Assets $254,000,000
Total Assets: $8,189,000,000
- Short Term Liabilities – $1,843,000,000
- Long Term Liabilities – $3,120,000,000
Total Liabilities: $4,963,000,000
By putting the formula, we get as follows:
LTD / A = $3,120,000,000 / $8,189,000,000 = 38.1%
The company has stated that 100% of these funds will be employed to build new factories and develop a chain of stores worldwide to strengthen the brand presence on each country. After adding this new bond the ratio will increase.
When adding the new amount of this calculation, the ratio will be:
LTD / A = ($3,120,000,000 + $2,225,000,000) / ($8,189,000,000 + $2,225,000,000) = 51.3%
As a result, the business leverage will increase significantly, which means the company will be in a much more sensitive position if its sales decline or if they face obstacles to develop these projects, or if the expected profitability of those is lower than the company’s estimations.
Analysis and Interpretation of Long-Term Debt to Asset Ratio
An alternative ratio known as the Long Term Debts to Fixed Assets can be also employed as a way to estimate how much of the business’ fixed assets are financed through long term debt.
The higher the percentage of that ratio is the easier it is to understand the destination and purpose of the leverage.
This ratio would fluctuate between 0 and 1 (in decimals) or between 0% and 100%. A higher value of the ratio is showed more leveraged a firm.
While a ratio of 0.5 (50%) or less is usually considered healthy, other important metrics must be evaluated in order to determine if the level of leverage is actually sustainable.
By analyzing all these ratios combined it will be easier to understand, what will the current situation of the company in relation to its debt.
In addition, considerate the purpose and destination of the borrowed funds is as important as determining the ratio itself.
By calculating the Long Term Debt to Fixed Assets Ratio, an investor can understand the portion of the Long Term Debt that may be employed to finance the business’ Fixed Assets.
While it is common that businesses issue debt to finance their capital expenditures, the fact that these funds are committed to assets that will be hard to turn into cash quickly.
A high Long Term Debt to Fixed Assets ratio indicates an increased risk of insolvency if the projects or the fixed assets themselves turn out to be less productive than expected.
In turn, a company that finances its current assets with long term debt is in a better position to quickly turn these assets into cash to pay for its obligations, as current assets are highly liquid as compared to fixed assets.
Practical Usage Explanation: Cautions and Limitations
As with any balance sheet ratio, you need to be cautious about using long debt to value a company, specifically for the total assets in the calculation. The balance sheet presents the total asset value based on their book values.
This can be significantly different compared with their replacement value or the liquidation value.
Short-term debt is considered several debt obligations by this ratio. A company might be at immediate risk of a large debt falling due in the next 1 year, which is not captured in the long-term debt ratio.
It’s also important to look at off-balance sheet items like operating lease and pension obligations. These items are not presented in the long-term liabilities section of the balance sheet, but they are liabilities nonetheless. If you don’t include these in your calculation, your estimates will not be completely correct.
Keep in mind that this ratio should be used with several other leverage ratios in order to get a proper understanding of the financial riskiness of a company.
There are some other relevant ratios that can be useful with this ratio are the Total debt to total assets ratio, Total debt to Equity ratio, and the LT debt to Equity ratio.
Used properly while considering all the loopholes, this metric can be an important tool to initiate a constructive discussion with the management about the future of the company.