Debt to Asset Ratio Analysis

The debt to asset ratio divides total liabilities by total assets, both read off one balance sheet at one date, so the result is the share of the carrying amount of the asset base that owners’ equity does not cover. Debt ratio, total debt ratio and debt to total assets all name that same quotient. Analysis turns on one choice the label hides. A numerator narrowed to the borrowings alone and one that takes every liability on the sheet give different answers off the same statement.

Which Liabilities Belong in the Numerator

Both numerators are in use, and on a balance sheet filed under Regulation S-X borrowings are kept apart from the rest even inside the current block. The rule requires the amounts payable at caption 19, accounts and notes payable, to be stated separately across seven categories, opening with banks for borrowings, factors or other financial institutions for borrowings, holders of commercial paper and trade creditors, and closing with related parties, underwriters, promoters and employees other than related parties, and others. Amounts applicable to the first three may be stated in a note rather than on the face of the sheet (17 CFR 210.5-02).

So a borrowings-only numerator reaches into the current block for those three lines, and for the current portion of long-term debt, which the same rule names among the items that may sit one caption further along under other current liabilities (17 CFR 210.5-02). Then it picks up the noncurrent borrowing caption, which long-term liabilities sets out along with the current-portion split and the point that debt is the borrowing subset of that class.

A total-liabilities numerator takes all of it, trade payables, accruals, lease obligations and deferred credits included. That total is a figure the reader foots rather than one the schedule reports, a point asset to liabilities ratio covers along with the reciprocal running the other way.

Two preparers can therefore hand a partner different debt ratios off one balance sheet without either being wrong, and some of the borrowing lines may not be on that sheet at all. A ratio quoted without its numerator definition cannot be compared with anything. Where a level actually binds a business, the loan agreement fixes both the measure and its terms, the ground covenants covers.

Operating Leases Move the Ratio Without New Borrowing

At the commencement date a lessee recognizes a right-of-use asset and a lease liability (FASB, Accounting Standards Update 2016-02, paragraph 842-20-25-1). That reaches operating leases as well as finance leases, subject to the short-term election covered in ASC 842 lease accounting.

The liability then sits apart from the rest of the liability side. A lessee presents finance lease liabilities and operating lease liabilities separately from each other and from other liabilities, on the face of the statement of financial position or in the notes, and is prohibited from presenting finance lease liabilities in the same line item as operating lease liabilities (FASB, Accounting Standards Update 2016-02, paragraphs 842-20-45-1 and 842-20-45-3).

Renewing an office lease therefore adds a liability and an asset without anyone borrowing. A total-liabilities numerator registers that; a borrowings-only numerator does not. A period-over-period move can be a new lease rather than a change in leverage, and the two conventions do not even move the same way when it happens.

A Worked Example on One Balance Sheet

Say a client balance sheet at year end carries the amounts below.

Total assets                          1,500,000
Total liabilities                       600,000
  bank term loan                        300,000
  operating lease liability             150,000
  trade payables and accruals           150,000

total liabilities / total assets   600,000 / 1,500,000 = 0.40
borrowings only  / total assets    300,000 / 1,500,000 = 0.20

One sheet, one date, and the first convention reports twice the second. Now say the business signs a new operating lease and records a lease liability with a right-of-use asset of the same amount.

new operating lease liability           100,000
new right-of-use asset                  100,000

Total assets                          1,600,000
Total liabilities                       700,000
  bank term loan                        300,000
  operating lease liabilities           250,000
  trade payables and accruals           150,000

total liabilities / total assets   700,000 / 1,600,000 = 0.4375
borrowings only  / total assets    300,000 / 1,600,000 = 0.1875

The first reading rises and the second falls. Adding the same amount to both sides of a quotient below one pulls it toward one, which accounts for the whole of the first movement, while the second moves only because the denominator grew.

What the Debt to Asset Ratio Is Confused With

Debt to equity. The denominator is shareholders’ equity rather than total assets, so it sets the liabilities against owners’ book equity instead of against the asset base, and the arithmetic tying the two together sits in equity multiplier.

Debt to income. This one is a consumer lending measure with no balance sheet in it. Under the ability-to-repay rule, a creditor considering a consumer’s monthly debt-to-income ratio must consider the ratio of the consumer’s total monthly debt obligations to the consumer’s total monthly income (12 CFR 1026.43(c)(7)(ii)(A)). Both sides of it are monthly flows, so nothing in it compares with a figure built from one balance sheet at one date.

Common Questions

Accountably places trained offshore accountants inside US CPA and EA firms, and a firm can grade a real block of its own ratio and lease schedule work through a trial task before anything client facing depends on it.