What is Debt to Equity ratio and Why it is so important?
What is the Debt to Equity Ratio?
The debt-to-equity ratio, which measures a company's financial leverage, is determined by dividing its total debt by the value of its shareholder’s fund. An essential metric in corporate finance is the debt-equity ratio. The debt-equity ratio can be used to assess the company’s performance against industry debt-equity ratio standards. The debt equity ratio is also known as the gearing ratio. It analyzes how much debt a business is using to finance its operations as opposed to 100% owned cash. More specifically, it shows whether shareholder equity would be sufficient to pay off all debts in the event of a downturn in business.
Understanding Debt to Equity Ratio
Debt-equity ratio considers financial figures from the balance sheet of a company. These balance sheet categories might include specific accounts that aren't often classified as "debt" or "equity" in the sense of a loan or the asset's book value. Further investigation is typically required to determine a company's true leverage because the ratio might be influenced by retained earnings/losses, intangible assets, and pension plan modifications.
Analysts and investors frequently alter the debt-equity ratio to make it more relevant and simple to compare other equities due to the uncertainty of some of the accounts in the key balance sheet categories. The inclusion of short-term leverage ratios, profit performance, and growth projections can also enhance the analysis of the debt-equity ratio.
Debt must be repaid by certain dates. A corporation may go into default and possibly even file for bankruptcy if it doesn't pay off debt or the interest that goes along with it on time. The probability of bankruptcy increases, other factors being equal, with the debt to equity ratio. Risk rises as a corporation takes on more debt.
Debt can also be advantageous. The return to stockholders may be improved. Shareholders receive a total return of more than what could have been made with equity capital alone if a company generates a profit over the cost of borrowing the money. Unfortunately, borrowing is not always advantageous. Sometimes the expense of borrowing money is greater than the profits it brings in.
Calculation of Debt-Equity Ratio
Debt - Equity Ratio = Total Liabilities / Shareholder’s Fund
The financial figures needed to evaluate the debt-equity ratio can be found in the Balance sheet of a company. Total shareholder equity must equal assets less liabilities, which is the balance sheet's rewritten form of the equation:
Total Assets = Liabilities + Shareholder’s Fund
What does a high debt-to-equity ratio signify?
A high debt-to-equity ratio implies that the company is financing its growth plans majorly through borrowings from the market rather than its own funds (equity). There is an inherent benefit for the company to opt for more debt one of which is that interest rate payments on debt is tax deductible for the company. It can help in tax-saving for the company. Also, since by taking more debt, the number of shares remains the same, a company can increase its overall earnings per share which is also known as financial leverage. There are certain industries like the telecom and infrastructure firms that are capital intensive and generally have higher debt-to-equity ratios than other industries.
What does a low debt-to-equity ratio signify?
A low debt-to-equity ratio implies that the company is financing its growth plans and capital requirements majorly through equity or its own funds. Investors generally prefer companies with a low debt-to-equity ratio as a high debt creates a higher charge on the assets of the company. As per law, companies are required to pay debt holders prior to the equity holders in case of liquidation of the company.
- Generally, a debt-equity ratio of 2.0 is considered to be a healthy ratio by analysts. Such a measure, where there is an equity instrument for every two debt instruments, is considered to be favorable.
- Factors like the growth of industry, competitors, and the profitability of the company influence the Debt-Equity ratio of other industries and standards, which usually reaches up to 5 or 8.
- An elevated Debt-Equity indicates a high level of risk. It means debt instruments are being used to fund the growth of the company.
- Especially when applying for a loan, debt to equity ratios can also be used by small and individual businesses for personal finance purposes. When income is disrupted or if there is a loss, lenders use the ratio to determine how loans can be repaid with interest.
What is a good debt-equity ratio?
A debt-to-equity ratio ideally should be roughly 2 or 2.5 and is generally seen as good, though it differs by industry. According to this ratio, the corporation receives around 66 cents of every dollar invested in debt and the remaining 33 cents in equity.
What if the debt-to-equity ratio is less than 1?
When the ratio is lower than 1, it is assumed that equity is used largely to fund the assets. In order to leverage its finances, a company that has a lower debt to equity ratio does so mostly through wholly-owned funds.
Is a high debt-to-equity ratio good?
The debt to equity ratio indicates the level of debt held by a corporation. Lenders and investors view a high debt to equity ratio as dangerous since it implies that the company is funding a sizable portion of its prospective growth through borrowing.