Example 1: High debt to asset ratio.

Christopher owns a bakery in midtown Manhattan called Lucky Charms. He’s recently been worried
about the finances of the organization as he prepares to apply for a loan extension. He decides to
conduct a debt to asset ratio test to determine the percentage of his expenses accounted for by
financing.

To begin the process, Christopher gathers the Lucky Charm’s balance sheet for November 2020 to
ensure that he has all the information he needs at his disposal.

With all the monthly data neatly together, he adds the long-term debt, bank loans, and wages payable
to get a total liability of $43,000. He writes this number at the top of the asset to debt ratio equation.

Christopher proceeds to find Lucky Charms’ total assets. He adds the accounts receivable, inventory, and
relevant investments. After calculations, his company’s total assets were $31,200. He writes this on the
bottom half of the division equation.

With both numbers inserted into the debt to asset ratio equation, he solves.

(43,000) / (31,200) = 1.37

The debt to asset ratio of Christopher’s business is well over one. This means that it cannot be converted
into a percentage.

What it means. The results of Christopher’s debt to asset ratio equation expresses a troubling reality for
the finances of his business.

A resulting value over one indicates that liabilities are being used to fund a business entirely and that the
company owes more than it’s taking in. It’s clear that this is the case with Christopher’s bakery, Lucky
Charms.
In the near future, the business will likely default on loans out of a lack of resources to pay. The majority
of incoming money is debt-based. This is very risky, and eventually, this catches up with any company.

Unfortunately, the financial standing of Lucky Charms seems to be progressively getting worse. His loan
extension will surely be denied.

Christopher should seek immediate action towards remedying the situation, such as hiring a financial
advisor to help. If he doesn’t do anything to alter the trajectory of his company’s finances, it will go
bankrupt within the next couple of years.

Example 2: Low debt to asset ratio.

Leslie owns a small business creating and selling handmade jewelry pieces. She wants to calculate her
debt to asset ratio to gauge her company’s financial health.

She starts by adding together all her business’ liabilities. She adds together the company’s accounts
payable, interest payable, and principle loan payments to arrive at $10,500 in total liabilities and debts.

Next, Leslie adds together all the assets of her business. She adds together the value of her inventory,
cash, accounts receivable, and the result is $26,000.

Finally, she plugs both of these figures into the debt to asset equation to find the raw decimal value of
her company’s ratio.

(10,500) / (26,000) = .403

Since Leslie’s debt to asset ratio is under one, she multiples it by 100 to get a percentage. The debt to
asset ratio of her small jewelry business is 40.3%.

What it means. The results of Leslie’s small business’ debt to asset ratio are under one, which is already
a good sign that it’s in acceptable financial health. A debt ratio of 40.3% means that more than half of
her business is funded by its own equity and not relying on borrowing money.

She is unlikely to default on any loan payments, and her small business is headed in the right direction. If
her jewelry company is new, she should continue to perform debt to asset ratio checks quarterly to
evaluate her business’ growth over time.

An investor named Sandra wishes to know if a utility company she interested in is a good candidate to
put her money on. Sandra decided to use the debt ratio of the company from last year’s results as one
of the bases of her decision. She can determine the company’s total assets to be $13,000,000 after
looking at the company’s balance sheet she obtained. She also found out that the company the
combined amount of short-term debts and long-term debts of $3,900,000. Can we calculate the
company’s debt ratio based on this data?

Let’s break it down to identify the meaning and value of the different variables in this problem.

Total liabilities: 4,900,000

Total assets: 13,000,000

We can apply the values to our variables and calculate the debt ratio:

Debt\: Ratio =\dfrac{4{,}900{,}000}{13{,}000{,}000} = 0.3769

DebtRatio=

13,000,000

4,900,000

=0.3769

In this case, the debt ratio would be 0.3769 or 37.69%.

From the result above, we can see that the utility company has taken the somewhat conservative
approach of not using too much leverage to finance the assets. This can be concluded from the less than
than 50% of the debt ratio. In this case, Sandra can be more rest assured investing in this company even
if for some reasons the company may not do well.