What it means
Every asset a business owns is paid for either with the owners' capital or with someone else's money. The total asset to capital ratio compares the two, so a result of 10 means the business holds $10 of assets for every $1 of capital, and the other $9 has been funded by creditors or depositors.
The ratio is the reverse of the capital ratio, which divides capital by assets. A bank with a ratio of 10 has capital equal to 10% of its assets, so the two measures say the same thing in different ways, one as a multiple and one as a percentage.
Banks and regulators watch the measure closely because a thin layer of capital leaves little room to absorb losses. If assets fall in value by more than the capital cushion, the institution becomes insolvent (unable to repay what it owes), which is why supervisors set minimum capital requirements.
Outside banking, the ratio is used by investors, lenders and credit analysts to judge how aggressively a company is financed. Property groups, finance companies and utilities often run higher ratios than software businesses, because their assets are steady and easy to borrow against.
The result depends heavily on what is counted as capital. Some analysts use total shareholders' equity, others use regulatory capital such as Tier 1 capital (the highest quality capital, mostly shares and retained profits), and the figures can differ a great deal, so always state the definition.
A high ratio is not automatically bad, because leverage can magnify returns when business is going well. The problem is the other direction, where a small fall in asset values or profits can wipe out a large share of capital very quickly.
In practice
Real-world examples.
Example
A community bank has $2,000,000,000 of assets and $200,000,000 of capital, giving a ratio of 10. Its board compares this with peers and with its own limit of 12 before approving a large increase in lending.
Example
A leasing company buys aircraft worth $500,000,000 using $50,000,000 of equity and the rest in loans. Its lenders look at the asset to capital ratio of 10 each quarter and may restrict new purchases if it rises above 12.
Example
A retail chain with $80,000,000 of assets and $40,000,000 of capital has a ratio of just 2. The finance director concludes that the company has plenty of room to borrow for a new distribution centre if the return justifies it.
Formula
Calculation
Total Asset to Capital Ratio = Total assets / Total capital
Suppose a regional lender reports total assets of $900,000,000 and total capital of $60,000,000. Ratio = 900,000,000 / 60,000,000 = 15, meaning $15 of assets for every $1 of capital. Turned around, capital to assets = 60,000,000 / 900,000,000 = 6.67%, so a fall of about 6.67% in the value of the assets would eliminate all of the capital.Case study
Seen in the real world.
Ashgrove Credit Union is an illustrative, fictional lender with $400,000,000 in assets and $32,000,000 in capital, a total asset to capital ratio of 12.5. The board wanted to expand its car loan portfolio by $60,000,000 over two years and asked the finance team how that would affect the ratio.
If the growth was funded entirely by new deposits, assets would rise to $460,000,000 while capital stayed at $32,000,000, lifting the ratio to 14.4. The finance team explained that retained profits of about $4,000,000 a year would reduce the effect, bringing capital to $40,000,000 and the ratio to 11.5 after two years, assuming the assets stayed at the new level.
The board approved a slower plan of $40,000,000 of new loans. The illustrative lesson is that growth consumes capital, so the ratio should be projected before a growth plan is approved and not discovered afterwards.
Watch out
Common mistakes.
- Comparing ratios from different organisations without checking whether capital means equity, Tier 1 capital or total regulatory capital.
- Treating a lower ratio as always better, when too little leverage can mean the business is not using its financing capacity to earn returns.
- Ignoring off-balance-sheet items such as guarantees and loan commitments, which expose the organisation to losses without appearing in total assets.
Questions
People also ask.
Is the total asset to capital ratio the same as the equity multiplier?
Often yes, because when capital means shareholders' equity, assets divided by equity is the equity multiplier used in the DuPont analysis of return on equity.
What is a good total asset to capital ratio?
It depends on the industry, with banks commonly running at ten or more and manufacturers at a much lower level, so compare against close peers and regulatory minimums.
How can an organisation reduce the ratio?
It can raise new capital, retain more profit, pay lower dividends or shrink its assets, for example by selling loans or paying down debt.
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