A beginner’s guide to Debt to Asset and Financial Leverage ratios.
Before this, we have spoken about Interest Coverage and Debt to Equity ratios under the Leverage Ratio category. Now, we will move to Debt to Asset and Financial Leverage ratios, which are also under the Leverage Ratio category.
But before that, as usual, this is what it’s all about:
When considering investments or trades, there are generally two approaches used by people to analyze their prospects. These approaches are known as technical analysis and fundamental analysis.
Each approach utilizes different methods to evaluate the worthiness of companies. In this case, we will focus on the fundamental investors, also known as value investors, and their way of evaluating investments.
Simply, fundamental investors seek to identify the intrinsic value of a company. They do this by examining the financial statements of the company, including the Profit & Loss Statement, Balance Sheet, and Cash Flow Statement. You can click on the hyperlinks provided for a comprehensive guide on how to read these statements.
How do they examine all the financial statements above? By using financial ratios! If you want a general overview of how financial ratios work, check out this article — Fundamental: Introduction to Financial Ratios.
There are four branches of financial ratios available: Profitability, Operating, Leverage, and Valuation.
Please also look at the chart below to get a full picture of where we are.
So, we are in the “Leverage Ratio” category while the types of ratios that we are going to discuss for now are the Debt to Asset and Financial Leverage ratios.
Generally, leverage ratios are financial metrics that measure the level of debt a company uses to finance its operations and investments. They provide investors with an understanding of the company’s ability to meet its debt obligations and how risky its capital structure is.
Before we start, for the examples below, we will use Apple’s annual report (FY2022, ends September ’22) which you can download here. There’s no particular reason why, it’s just that Apple’s report is relatively structured and easy to use.
The Debt to Asset ratio is a financial ratio that measures the proportion of a company’s assets that are financed by debt. It provides insights into the extent to which a company relies on debt to fund its operations and investments.
The Debt to Asset ratio is commonly used by investors, lenders, and analysts to evaluate a company’s capital structure and financial health. However, it’s important to consider the industry norms and compare the ratio with peers and historical data to gain a comprehensive understanding of a company’s financial position.
A higher Debt to Asset ratio suggests that a larger portion of the company’s assets is financed through debt. This can indicate higher financial risk since a significant portion of the company’s assets is owed to creditors. It also implies that the company has a higher level of debt obligations and interest payments, which can impact its financial flexibility and profitability.
The formula for Debt to Asset ratio is as follows:
Debt to Asset = Total Debt / Total Asset
Let’s look for the details in Apple’s financial statements. In its balance sheet, you can find its total debt in its “liabilities and shareholders’ equity” section which states as below. We took the “term debt” under both current liabilities and non-current liabilities — which refers to the debt for both terms (current = short term, non-current = long term).
Note how we don’t take the income inclusive of its other income or expenses? That’s because “other income / expense” here also includes interest payment. EBIT is before interest and tax — we want it raw! How did we know other expenses here include interest payment? Look at the Interest Payment part below.
As for its Interest Payment, we can have a look at the note to Apple’s financial statements (Note 4), in which it details out the “interest expense” of Apple at $2,931 million. (See how it puts interest payment under “other income/expense”? That’s why we don’t consider this when looking for EBIT).
Total debt = 11,128 + 98,959
Total debt = 110,087
As for its total asset, we can look for it (also) in the balance sheet, where it puts it it at $352,755 million.
Now, let’s move to the formula!
Debt to Asset = Total Debt / Total Asset
Debt to Asset = 110,087 / 352,755
Debt to Asset = 0.31 or 31% if you want it in percentage.
So, you can conclude that 31% of Apple’s assets are financed by debt. Is it good? Is it bad? To know the answer, you’ll have to look at Apple’s other ratios as well and compare Apple’s ratios with its peers to get a sense of how everyone else in the industry is generally doing.
The Financial Leverage ratio is a financial ratio that measures the proportion of a company’s total assets that are supported by equity. A higher Financial Leverage ratio suggests that a larger portion of a company’s assets is leveraged compared to its equity — in short, the higher it is, the riskier a company is.
So, here goes the formula:
Financial Leverage = Total Asset / Total Equity
Let’s look into its balance sheet where the total assets are at $325,755 million.
As for its Total Equity, it can also be found in the balance sheet, which puts it at $50,672 million.
Now, back to the main formula.
Financial Leverage = Total Asset / Total Equity
Financial Leverage = 352,755 / 50,672
Financial Leverage = 6.96
Easy, isn’t it? Now the only step you need to take is the same as above, which is to compare it with other ratios and other companies to get a grasp on where Apple stands.
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