What is the Debt to Equity Ratio?

The debt to equity ratio is usually used to estimate a company’s economic leverage. It is designed by dividing a company’s total liabilities by its stakeholder equity.

The debt to equity ratio is an important method that is used in the corporate finance sector. It is a measurement of the mark on which a company is financing all of its operations through debt versus wholly owning the company’s funds.

More precisely, it primarily reflects the ability of stakeholder equity to cover all unpaid debts in the event of a business recession. The debt to equity ratio is also a particular type of gearing ratio.

Formula to Calculate Debt to Equity Ratio?

Debt to Equity Ratio =  Debt / Shareholders Equity

 

Debt = Short term Debt + Long Term Debt + Other Fixed payments

Shareholders Equity =  Equity Shares + Preference Shares 

All the information needed for the Debt to Equity ratio can be found in any company’s balance sheet. The balance sheet always requires total stakeholders Equity for equal assets minus liabilities, which is a repositioned variety of the balance sheet equation:

Assets=Liabilities +Shareholder Equity

These balance sheets are categorized in such a manner that they may contain specific accounts. That would not usually be considered “Debt” or “Equity” in the traditional sense of a loan or the book value of an asset. As the ratio can be inaccurate by retained earnings or losses, intangible assets, and pension plan adjustments, additional research is usually needed to understand a company’s true production potential.

Because of the uncertainty of some of the financial records in the primary balance sheet categories, experts and stakeholders will often modify the equity ratio’s debt, which is more practical and easier to compare between different stocks. The debt to equity ratio study can also be enhanced by including short-term leverage ratios, profit performance, and growth opportunities.

What does the Debt to Equity ratio tell us?

As it is given that the debt to equity ratio deals with the company’s debt relative to the worth of its net assets, it is mainly used to measure the extent of a company that is taking on debt based on leveraging its assets. A high debt to equity ratio is frequently accompanying by a high risk. It means that a company has been aggressive in financing its growth with debt.

If there is a lot of debt used for financial growth, a company could theoretically generate more earnings than it would have not with that financing. If leverage increases incomes by a more significant amount than the debt’s cost (interest), stakeholders should expect benefits.

However, if the cost of financial debts considers, there is an increase in income generated, and in this case, share values may come down. The rate of debt may vary with the market conditions. So there might include unprofitable borrowing, which may not be apparent at first to improve current ratio.

Fluctuations in long-term debt and assets incline to have the most significant effect on the debt-to-equity ratio because they tend to be more extensive financial records than all short-term and short-term assets. If investors want to appraise a company’s short-term leverage and its ability to meet debt responsibilities that must be funded over a year or less, they can use other ratios.

What is the modification to the Debt to Equity Ratio?

The equity portion of the stakeholders in the balance sheet is equivalent to all the total assets minus liabilities, but that is not the same thing as assets minus the debt related to those assets.

A similar approach in resolving this issue is to adjust the short-term debt into the long-term debt to equity ratio. A method like this helps an expert focus on the most critical risks.

Short-term debt is still considered a part of a company’s overall leverage, but because these liabilities will be paid in one year or less, they aren’t as risky.

E.g., imagine a company with $2 million in short-term payables (wages, accounts payable, and notes, etc.). For example, $1 million in long-term debt, compared to a company with $1 million in short-term payables and $2 million in long-term debt.

If both companies have $2.5 million in stakeholder equity, they both have a liability to equity ratio of 1.00. The risk from leverage is equal on the surface, but the second company is at much more risk in reality.

As mentioned in the debt of equity ratio rule, short-term debt tends to be less expensive than long-term debt. It is less sensitive to fluctuating interest rates, meaning that the second company’s interest expenses and cost of capital are higher.

If interest rates drop, long-term debt will be needed to be refinanced, which can be further increased in costs. An increase in interest rates would seem to favor the company with more long-term debt, but if bondholders can exchange the liability, it could still be a disadvantage.

How to analyze the Debt to Equity Ratio?

Below are some points that help us analyze the Debt to Equity Ratio-

Regulate the company’s liability and equity. All the information needed to make this calculation can be found on the company’s balance sheet. You have to be sure about or make some decisions about which of the balance sheet accounts to include in your debt calculation.

Funds contributed by the stockholders are also referred to as equity and even the company’s earnings. The balance sheet should include a figure mentioned as total equity.

While determining debt also include interest-bearing, long-term debt such as notes payable and bonds. It should be sure that the current amount of long-term debt is included. We will find this in the current liabilities section of the balance sheet.

Specialists often leave out current liabilities, such as accounts payable and accrued liabilities. This provides some minor information about how a company is leveraged. This is because they don’t reflect long-term obligations and only the day-to-day operations of the business.

Expenditures that are not listed on the balance sheet should be listed. Companies will sometimes keep certain expenses out of their balance sheets.

While calculating debt, certain off-balance sheet liabilities should be included. Two joint off-balance sheet liabilities are operating leases and unfunded pensions. These kinds of expenditures are primarily large enough to include in the debt to equity ratio.

Other debt to look out for may come out from other joint ventures or research and development partnerships.

The Debt to Equity Ratio for personal finances-

The debt to equity ratio can be applied to any personal financial statement as well. In this case, it is also called the personal debt to equity ratio. “Equity” refers to the difference between the total value of an individual’s assets and the total value of their liabilities.

The personal debt to equity ratio is often used when a small business or an individual is applying for a loan. Creditors use debt to equity to evaluate how the borrower can remain to make loan payments if their income was temporarily interrupted.

E.g., a prospective mortgage borrower who is on the job for a few months is more likely to remain to make payments if they have more assets than debt. Applying for a small business loan or line of credit, an individual can do so. If any business owner has an excellent personal liability to equity ratio, they can continue making loan payments while their business is growing.

Debt to Equity Ratio vs. The Gearing Ratio-

Gearing ratios found a broad category of financial ratios in which the debt to equity ratio is the best example. “Gearing” also refers to financial leverage.

Gearing ratios mainly focus on the heavy concept of leverage than other ratios used in accounting or investment study. This theoretical term prevents gearing ratios from being precisely calculated or deduced with consistency. The fundamental principle generally undertakes that some leverage is good, but too many places in an organization are at risk.

Sometimes gearing is differentiated from leverage at a fundamental level. Leverage states the amount of debt acquired to invest and obtain a sophisticated return while gearing states to debt along with total equity or an appearance of the percentage of company capital through borrowing. This difference is personified between the debt ratio and the debt to equity ratio.

Benefits and Limitations of Debt to Equity Ratio-

BENEFITS-
Some of the benefits are given below:

1. Indicative of residual profit:

The ratio indicates how much debt is present in assessment to the amount of equity. So the ratio can be used to decide how much profit will be offered for equity holders because they only have the outstanding claim over the company’s profits.

2. Indicative of Risk:

A high ratio indicates a greater risk as the interest expense related to debt is also higher for a high debt company. It is a compulsory outlay even when the company is not making profits. Therefore the risk increases to invest in such companies. By studying this ratio, the stockholder can decide whether the security fits within his risk restrictions or not.

LIMITATIONS of Debt Equity ratio-

Some of the limitations are:

1. Multiple variants:

This ratio has several differences it as clarified earlier. Therefore, it is not easy to draw comparisons without altering the two companies’ ratios and bringing them to the same page. Sometimes, such information might not be readily available in the accounts and might need more research.

2. Volatile inputs:

This ratio calculated on the market value for companies with unpredictable share prices or debt prices might not make sense. It might require smoothening, which is a predictable procedure and therefore may not have enough accuracy.

3. Industry Specific:

This ratio changes from one industry to another as every industry has different investment needs. These Industries might require massive speculation in fixed assets and generally have a higher liability to equity ratio. Initially, the significance required might be too massive for a company to rise through equity. Therefore the ratio does not help in the inter-industry assessment.

 

Benefits and Drawback of a High Debt to Equity Ratio-

BENEFITS OF HIGH DEBT TO EQUITY RATIO-

A higher debt-equity ratio can’t be wrong because it shows that a company can efficiently service its debt requirements (through cash flow) and leverage to grow the equity returns.

In the below example, we can see how using more liability (increasing the debt-equity ratio) can increase the company’s return on Equity (ROE). Using the liability instead of equity, the equity account is smaller, so equity is higher.

Typically the cost of debt is lower than the cost of equity which is also a benefit. Therefore, the rise in the debt to equity ratio (up to a certain point) can decrease a company’s weighted average cost of capital (WACC).

DRAWBACKS OF HIGH DEBT TO EQUITY RATIO-

If a company has a debt to equity ratio that’s too high is refer to as the opposite of the above example. So if there is any loss, it will be compounded down, and the company may not be able to service its liability.

If the debt to equity ratio increases high, then the cost of borrowing will rise steeply, as will the Cost of Equity, and the company’s WACC will get enormously high, which would result in driving down its share price.

Conclusion-

So as we know, the Debt to Equity Ratio is a measurement of the amount of leverage a firm has and acts as an assessment tool in investment research. A higher ratio suggests the level of risk a company has, and therefore it helps the stockholder decide whether or not an investment is worth investing in.

As there are many alternatives to the ratio, the investor or stockholder needs to be careful while comparing it and understand correctly what the elements of the inputs of the ratio are before blindly giving the advantage to the company with a lower ratio.

Frequently Asked Question-

What is good Debt to Equity Ratio?

Ans. A good debt-to-equity ratio depends on the nature of the business and its industry. Generally, debt to equity ratio below 1.0 would be seen as primarily safe, whereas ratios of 2.0 or higher would be measured as risky. Some industries, such as banking, hold much higher debt-to-equity ratios than others.
Note that the debt to equity ratio, which is too low, maybe a negative signal, indicating that the company is not taking advantage of debt financing to expand and grow.

What does it mean for the Debt to Equity Ratio to be Negative?

A company with a negative debt to equity ratio means that the firm has negative shareholder equity. So, in other words, it means that the firm has more liabilities than assets. In most cases, this is considered a hazardous sign, indicating that the company may be at risk of insolvency.

How can the Debt to Equity ratio be used to measure a company’s riskiness?

A higher debt to equity ratio sometimes makes it harder for a firm to obtain financial support in the future. This means that the firm may have a tough time serving its existing debts. Very high debt to equity can suggest a credit crisis in the future for the firm, including avoidance of loans or bonds or even bankruptcy.

Which industries have high Debt to Equity ratios?

In the service sector like the banking and financial, a relatively high debt to equity ratio is commonplace. Banks carry greater amounts of debt because they own significant fixed assets in the form of branch networks. Other industries that mostly show a relatively more excellent ratio are known as capital-intensive industries, such as the airline industry or large manufacturing companies, which consume a higher level of debt financing as a common practice.

What does a debt-to-equity ratio of 1.5 indicate?

Debt to equity ratio of 1 would indicate that the company in question has $1 of debt for every $0.5 of equity. To clarify, suppose the company had assets of $3 million and liabilities of $1.2 million. Because equity is equal to assets minus liabilities, the company’s equity would be $800,000. Its debt to equity ratio would therefore be $1.2 million divided by $800,000, or 1.5.