From the course: Accounting Foundations: Leases

Debt ratio and asset turnover ratio

From the course: Accounting Foundations: Leases

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Debt ratio and asset turnover ratio

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- Here are the numbers from the financial statements of hypothetical Company T: total liabilities, $80,000, total assets, $200,000, and sales of $500,000. In doing some simple analysis of these numbers, we will compute two generally used financial ratios: the debt ratio and the asset turnover ratio. The debt ratio is computed by dividing total liabilities by total assets, and the asset turnover ratio is computed by dividing sales by total assets. The debt ratio is the percentage of the total assets that were purchased with borrowed money. This reflects how aggressive a company has been in using financial leverage. The asset turnover ratio is the number of dollars of sales generated each year by each dollar of assets. This reflects how efficiently a company is using its assets to generate sales. So let's compute these ratios using the reported financial statement numbers of Company T. We'll start with the debt ratio. The debt ratio is 40%. This number means that 40% of the money that Company T needed to buy its $200,000 in total assets came from borrowing. The other 60% must have come from owner investment. Now is this 40% debt ratio value high or low? In other words, is that a lot of financial leverage, a normal amount of financial leverage, or an abnormally high amount of financial leverage? Well, for a large U.S. operating company, the typical debt ratio is between 50% and 60%. So 40% is kind of low. What this means is that if Company T goes into a bank and wants to borrow more money, the bank is going to look at this 40% debt ratio and say okay, your existing leverage is kind of low. It is certainly reasonable to consider you for an additional loan. Sit down, let's talk. Now let's compute the asset turnover ratio. Again, this is computed by dividing sales by total assets. In the case of Company T, the result is 2.5. This means that Company T generated 2.5 dollars in sales this year for each dollar of assets. Is this 2.5 asset turnover ratio value high or low? Is Company T using its assets efficiently to generate sales? In this case, we don't know. Interpreting the asset turnover ratio value requires comparison information, information about the same company in prior years to see trends and information about other companies at the same time in the same industry. So for example, it wouldn't make any sense to compare the 2018 asset turnover ratio value of Walmart of 2.35 to the 2018 asset turnover ratio value of Coca-Cola of .38. They're in different industries, so the numbers should not be compared. In our example, we don't know Company T's industry or the company's history. So we don't know whether Company T is using its assets efficiently to generate sales. All we know is that this year, Company T generated 2.5 dollars of sales for every one dollar of assets. There we are. Company T's debt ratio is 40%. Company T's asset turnover ratio is 2.5. Now what about Company T's leased assets? Were they used in generating the sales? Absolutely. Are they reported in the balance sheet? No, because they are accounted for using traditional operating lease treatment. Because the operating leases are not reflected in the balance sheet, does the reported debt ratio really tell us what we need to know about Company T's leverage? Do we really understand how efficiently Company T is using its assets, all of its assets, to generate sales?

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