What is the Debt to Assets ratio and why is it important to a small business owner like Ryan Armstrong?
The Debt to Assets ratio is a key ratio that is looked at by lenders and potential partners alike and hence it is very important to a small business owner like Ryan Armstrong. Just like the Debt to Equity ratio, it measures how much leverage a small business has employed to deploy the assets it currently has. Unlike the Debt to Equity ratio which measures the amount of debt to the shareholders equity, the Debt to Assets ratio looks at the leverage that is employed on the Assets of the small business.
The Debt to Assets ratio is measured by dividing the Total Liabilities or debt of a small business by its Total Assets. As a general rule the lower the Debt to Asset ratio the better it is for a small business like Ryan Armstrong, but it does not always present itself as an advantage as we will see in our discussions below.
Is an increasing Debt to Asset ratio an indicator of future problems for a small business owner like Ryan Armstrong?
Yes - for the most part. An increasing Debt to Asset ratio could come about due to two reasons - one if the Total Debt of the small business is increasing and / or if the Total Assets of the firm are being reduced. An analysis will have to be conducted Ryan Armstrong to determine what is the reason for the increase in the Debt to Asset to ratio and then make strategic and tactical decisions to bring the ratio back in line with historical standards.
When the Debt to Asset ratio is increased due to the increase in the firms Total Debt or liabilities then Ryan Armstrong has to take some time to understand the reason for the increased indebtedness of the small business. It could well be that the business has tapped into its business loan or line of credit to use the funds for expansion or the business may have taken on a new loan or note to add to the existing debt it has. In this case a determination will have to be made to ascertain if the reason for the increased indebtedness is justified.
If it is debt that has been taken on to expand the operational infrastructure then it may take some time to translate into a higher cash flow. On the other hand if the debt has been undertaken to buy a new piece of equipment then you will most likely also see a corresponding increase in the Total Assets of the firm. The key item to understand in this scenario is that in the end the Total Debt to Asset ratio should come back to a more normal level and an constantly increasing ratio is not good.
On the other hand if it is determined that the level of debt has remained the same but the Total Assets of the firm have reduced in number causing the Total Debt to Assets ratio to go up, it may well have to do with the disposal of an asset or the reduced value of the Total Assets due to depreciation. This is a normal in the couse of a business - for example if you are a dentist office the Total value of your Assets like equipment are expected to go down every year since the value of these assets is now reduced. By the same token, when you add a new piece of equipment by replacing an older asset, the Total Asset value will increase.
Does having a lower Total Debt to Asset ratio give a small business like Real Estate Funding Solutions a competitive advantage?
Yes - for the most part. Having a lower Debt to Asset ratio for a small business like Real Estate Funding Solutions indicates that it is employing lesser leverage than the competition and as such will be able to handle the cost of covering the debt much better than the competition which may be leveraged to the hilt and not able to withstand any slowdown in its business.
In addition having a lower relative Debt to Asset ratio for a small business like Real Estate Funding Solutions will give it the ability to raise capital with relatively more ease than competitive businesses that don't have a low leverage. When lenders are looking to make business loans they want to see how much the asset base of the small business is before they make the loan. Thus if the competition has a higher levaraged Asset base then lenders will probably think twice before putting out money as opposed to a small business like Real Estate Funding Solutions that has a lot more assets to cover their liabilities. What this means of course is that if the small business were to default on the loan, the lender has a much better chance at getting their principal back since there are a lot more assets to go after and liquidate to recover the investment.
Thus if lenders look more favorably at small businesses with lower debt to equity ratios, for sure those smaller business will have an advantage raising capital from lenders and potential partners then businesses employing more leverage.
A point must be made however about small businesses that choose to employ no leverage at all - of course these businesses will have the lower Debt to Asset ratios than their competitors. However they will also have a disadvantage in that by choosing not to employ any leverage and take on no debt at all, they are also running the risk of the owners having to come up with equity for every things thus making the expansion of the business a much slower affair.
As is well known, growing organically using only equity takes a lot longer than expanding using a combination of your own capital and somebody else's money. While we don't recommend that small businesses take on too much debt and a balance has to be struck as always with every business decision - having access to business loans and lines of credit is always a good things. This is how a small business owner like Ryan Armstrong can take advantage of opportunities like buying up a competitors assets on the cheap thereby gaining a tremendous advantage.
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