There are several financial figures that represent your financial health—in specific areas and overall. While some will help you better understand your current situation, others can help you know where you're meant to be and the path you need to take to get there. Lenders (and investors if you're running a business) also use this data to determine your financial risk and whether you qualify for certain financial products, such as loans. One of these figures is your debt to asset ratio.
Your debt to asset ratio indicates the percentage of assets you're currently financing with debt. The equation is calculated by taking your total debt and dividing it by your total assets. Besides figuring out your ratio, it's important to understand what it means for your financial health.
Although the debt to asset ratio is typically applied to companies in order to assess their financial standing, it's also handy for personal finance. In this post, we'll explain exactly what your debt to asset ratio is, why you need to know it, how to calculate it, what a good ratio is, and more. Let's get started!
Debt To Asset Ratio Definition
Also known as a "debt ratio," "liability to asset ratio," and "total debt to total asset ratio," your debt to asset ratio measures your degree of financial leverage or solvency. In layman's terms, it calculates how much debt you have compared to how much your assets are worth. This is a good portrayal of your level of risk to lenders.
If the ratio is greater than one (i.e., 100%), you have more debt than assets. If the ratio is less than one (i.e., less than 100%), you have more assets than debt. In the case of the former scenario, this increases your risk profile in the eyes of prospective creditors or investors. The result is that you may find it more difficult to acquire funding.
Even if a lender does accept your application based on factors like your credit report and payment history, the chances are that you'll end up paying a high-interest rate and have less favorable repayment terms.
However, if the latter scenario is true and you have more assets than debt, your perceived risk is diminished. In this case, you're more likely to be granted approval for funding. In addition, you'll also probably secure lower interest rates, which ultimately lowers the overall cost of what you borrow.
There are times when a strong debt to asset ratio might not be as influential as you'd like when it comes to obtaining funds, such as a loan. Lenders want to know how you'll handle the loan, so they consider things like what may happen if you suddenly find yourself jobless or with massive medical bills. They want to ensure you'll still be able to sustain your short-term liabilities.
Therefore, when potential lenders calculate your debt to asset ratio, they generally take into account the costs of the loan you're seeking to attain, as well as your total debt. This gives them better insight into whether you can adequately service the repayments every month.
Basically, they want you to have some financial breathing room if things go wrong. If interest rates rise or your financial circumstances change in any way, you need to have a big enough buffer to endure the impact on your finances.
Why You Should Know Your Debt To Asset Ratio
Your debt ratio is just one of several debt ratios that matter most to you, your life, and your business (if you have one). This particular calculation helps you understand whether you're over-borrowed or facing possible solvency issues. Depending on your situation, you may be insolvent. This means you don't have the ability to repay your debts even if you liquidated all of your assets.
One of the key times to consider your debt to asset ratio is when you're contemplating taking out a new loan. Before applying, you should always use your debt to asset ratio to determine if you have already borrowed beyond your capacity to repay the debt. If so, it's highly advisable that you don't take out a new loan, as it will only increase your liabilities. Instead, you should wait until you can square off existing loans or—at the very least—decrease your debt to asset ratio to a point where your assets more than cover your debts and then some.
How To Calculate Debt To Asset Ratio
The formula for calculating your debt to asset ratio is as follows:
Debt to Asset Ratio = Total Debt / Total Assets
To express this figure as a percentage, you then multiply the answer by 100. The equation should look something like this:
[Total Debt / Total Assets] X 100
Your total debt (also referred to as liabilities) includes common debt obligations like a home loan, car loan, personal loan, student loan, credit card, or any money borrowed from private lenders (such as family and friends) that you need to repay, unpaid taxes, and other financial agreements where you're required to reimburse a creditor.
Your total assets consist of all that you own. This includes your house, land or other property, car, jewelry, investments, cash, computers, etc. If you only include your liquid assets such as your cash and cash equivalents, checking and savings account balances, certificates of deposit, and money market accounts instead of total assets (i.e., liquid assets plus fixed assets), the ratio is then referred to as your "liquid assets coverage ratio."
So, what does the debt to asset ratio look like in real life?
The equation requires two key inputs: total debt and total assets. To ensure you find the right answer for your own situation, let's walk through the math step-by-step:
Step 1: Add Up Your Total Debt.
This should reflect both short-term and long-term liabilities. Short-term liabilities are those debt obligations that are due within the next 12 months, such as credit card balances. Long-term liabilities are debts that will take longer than a year to pay off, such as a mortgage.
Step 2: Add Up The Value Of Your Total Assets.
Your total assets are a combination of cash, savings, and personal property. If an item carries positive value in monetary terms, it's an asset. Let's break this down even further by category.
Cash and cash equivalents: This refers to funds you can access easily, including cash on hand, savings accounts, money market accounts, and the cash value of life insurance policies.
Investments: This category incorporates the current value of any investments you have, such as stocks, bonds, mutual funds, and certificates of deposit.
Personal property: Here, you'll want to add up the potential sale value of what you own. This includes your house, car, and other items like jewelry, collectibles, art, appliances, etc.
Retirement accounts: If you have money in an IRA, pension fund, or another type of retirement account, you should include it as part of your total assets.
Once you have your total debt and total assets figures calculated, it's time to move to the final step.
Step 3: Plug Your Figures Into The Debt To Asset Ratio Formula.
Divide the number you calculated as total debt by the number you calculated as your total assets. When you have the answer, multiply that figure by 100 to attain the percentage.
Let's say that you're $48,000 in debt but have assets to the value of $120,000. In this case, your calculation would look like this:
48,000 / 120,000 = 0.4
0.4 X 100 = 40
Therefore, your debt to asset ratio is 40%.
Pretty simple, right?
But how do you know if your ratio is a good or bad thing?
What Is A Good Debt To Asset Ratio?
A high debt to asset ratio means you owe more. It also means you run more risk by opening new lines of credit. Unfortunately, this tends to diminish your borrowing capacity, which is why it's smart to know what your debt to asset ratio is—especially if you're a freelancer or business owner.
However, what's considered a "good" debt to asset ratio varies depending on your specific situation, as well as your prospective lender. Most financial experts recommend that you try to maintain a ratio of 40% or less as a rule of thumb. This is usually still an acceptable ratio to most lenders. While you might pay higher interest rates on some loans, you are at least likely to qualify for the loan in the first place.
Typically, lenders view debt to asset ratios of 60% or above as relatively poor. You may even notice that you struggle to meet your debt obligations as you get closer to this figure. Therefore, maintaining a ratio of 40% or lower not only makes you appear attractive to lenders as a potential borrower but also ensures you keep from falling behind on paying off debts each month.
If you're a business owner, one thing to keep in mind is that how much your debt to asset ratio affects your business depends on your industry. For example, if you operate a business that doesn't require much debt upfront to get started, such as a consulting or photography business, you'll more than likely have a low debt to asset ratio on average.
Unfortunately, the opposite is true for businesses like retail stores and manufacturing companies that do require a lot of debt to start. Although it's not always the case, it's quite common to see high debt ratios for businesses within these industries.
The good news is that whether you're tracking your debt to asset ratio for personal or business purposes, there are some simple ways to lower your ratio.
How To Improve Your Debt To Asset Ratio
Besides helping you lower your debt to asset ratio, the following tips can help you improve other debt ratios, boost your credit score, and strengthen your overall financial health. So, without further ado, let's jump into our top seven tips.
1. Pay Down Your Debt
By increasing the amount you pay on your debt each month or making extra payments, you can accelerate the rate at which your total debt in your debt to asset ratio equation decreases.
Keep in mind that any balances carried over from one month to the next start to accrue interest immediately. In addition, a sizeable portion of what you pay goes toward serving interest rather than the principal amount owed. This can get exceptionally expensive over time. However, actively focusing on reducing your debt amount can go a long way to improving your debt to asset ratio and saving you money in the long run.
2. Avoid Taking On More Debt For Now
Perhaps one of the more obvious ways to lower your debt to asset ratio is to avoid sinking yourself into more debt. Part of this means not applying for more loans. The other part requires you to curb your spending. This goes hand in hand with our next tip.
3. Wait To Make Large Purchases
It's tempting to whip out your plastic and charge large purchases to your credit card or take out a loan to cover a big expense. However, you should consider postponing big buys so that you can save for a larger down payment. This way, you'll need to use less credit to fund the purchase, which in turn won't wreak havoc on your debt to asset ratio.
4. Earn More Money
Easier said than done, but millions of people around the world are supplementing their main source of income with side hustles. These days, it's easier than ever before to start a side business while working full-time. The benefit of these additional streams of revenue is that they can help you pay off debt faster and increase your total assets, whether you choose to put more money into savings and investments or simply keep it as cash on hand.
5. Build Your Savings
This applies to both general savings and your emergency fund. One of the biggest reasons people get into a mountain of debt is because they use their credit cards and personal loans to cover shortfalls and emergencies. Savings not only count toward your asset calculations but also help you avoid needing debt to fund emergency situations or any deficit in your monthly budget.
6. Decrease The Cost Of Your Debt
Did you know there are ways you can reduce the overall cost of your debt? One of the most effective methods is to negotiate a lower interest rate with your creditors. If you can prove you have an excellent payment history and good credit score, some creditors may be willing to decrease your interest rate.
You can also look at applying for a balance transfer, which is something we discuss in-depth in our post on the best ways to refinance credit card debt. In its simplest form, a balance transfer means transferring the balance of one or more high-interest credit cards to a balance transfer card with a better pricing structure (i.e., lower interest rates). Sometimes, you can find balance transfer cards with a 0% introductory offer where you don't pay interest for a specified period.
Ultimately, these methods decrease the overall cost of your debt, which is something lenders take into account when reviewing your debt to asset ratio.
7. Consider Debt Forgiveness
Depending on why you want to reduce your debt to asset ratio, you might want to think about debt or loan forgiveness. Unfortunately, it can reflect negatively on your credit report, so it's not a decision you want to take lightly. Instead, view this tip as a last resort if you're struggling to lower your debt and increase your assets in other ways.
Whatever you do, be sure to re-calculate your debt to asset ratio at the end of every month so that you can see the progress you're making. Decreasing your figure might take some time and effort if your ratio is extremely high, but the following tips we just covered and perseverance are keys to your success.
Asset Liability Ratio vs. Debt To Asset Ratio: What's The Difference?
Quite simply: nothing.
As you read earlier, the debt to asset ratio goes by several different names, which can be super confusing. However, they all mean the same thing: dividing what you owe by what you own.
Is Your Debt To Asset Ratio The Same As Your Debt To Income Ratio?
They are similar in that they help you measure your financial health, but your debt to income (DTI) ratio compares how much you owe on a monthly basis to how much you earn. Essentially, the equation considers how much of your gross monthly income (i.e., the amount you earn from all sources before tax and other deductions) goes toward payments for your mortgage or rent, credit cards, and other debt.
Working out your debt to asset ratio on a regular basis is a great way to keep an eye on your personal finances. Since your ratio could mean the difference between successfully securing a loan for your personal use or business and not getting a nickel from a lender at all, you'll want to ensure you maintain a good ratio that prospective lenders will look on favorably.
Shawn Manaher is a former financial advisor, has founded 5 online businesses, and is a coach, speaker, podcast host, and author. He's been featured on Forbes, The Consults Corner on TAE Radio, The Writing Biz, What's Your Story, and more.