Debt to Equity Ratio
Debt to equity ratio
What Is The Debt to Equity Ratio?
A company's debt-to-equity ratio (D/E) is calculated by dividing its total debt by the shareholders' share. These figures factor heavily into a company's financial statements, featured on the balance sheet.
Where we see this ratio used is in assessing the company's overall financial leverage. Gauging your debt-to-equity ratio gives you an idea of how much of your company is financed through debt and wholly-owned funds. More importantly, it's a measurement of the shareholders' ability to cover your outstanding debts if you go through a downturn.
A Low D/E
With low debt-to-debt ratios, this indicates less financing through debtors than through shareholders. A higher rate would indicate the company is borrowing more to finance its operation. Too high a debt level and the company is exposed to various risks, chief of which is the risk of bankruptcy when business performance dips.
Even when a company isn't making enough of a profit to fulfill its various obligations, minimum payments for its loans still need to be paid. For leveraged companies, where loans finance operations, a consistent loss in earnings can lead to problems.
Your debt ratio is calculated by dividing your total debt by your total overall capital. All elements are reported on the balance sheet, hence the debt ratio is also commonly considered a balance sheet ratio. All of which is fair and well, but is it best to keep your debt to equity ratio high or low?
Advantages Of A High D/E Ratio
Despite the alarming sounding name, higher debt ratios can actually be advantageous. Companies can deal with debt liabilities through any given set of cash flows and leverage in order to increase their returns on the stock.
By using debt instead of equity, your equity account will also be smaller than otherwise. Being forced to work at this level also means a higher return on equity, overall. Debt costs are also, generally speaking, lower than capital costs. So raising the D/E ratio may lower weighted average capital costs (WACC) for your company.
Disadvantages of High D/E Ratio
If you haven't noticed yet, the truth of the matter is there's no such thing as an "ideal debt-equity ratio" for all businesses. Everybody is different, and some operations do better with a high number than others.
There were always going to be some downsides to a high D/E ratio, however. If your company's ratio is far too high, losses can occur and your business may not be ready to handle the resultant debt. When your debt ratio becomes too high, it also drives your borrowing costs up. Not only this, but stock prices are also likely to fall.
What We Learn From This Ratio
The debt ratio measures a company's debt to the net asset value. With this in mind, it is most often used to measure to what extent a company is in debt so as to utilize its assets. High debt-to-capital ratios are usually associated with high risk. That means the company worked to finance growth with debt, which is both a bad indicator of their approach and their potential stability.
Where large amounts of funds are used to finance growth, companies can generate more income than they may get without any funding. If leverage increases income more than the cost of the debt interest itself, it's reasonable to expect a profit.
Where debt financing costs are greater than the actual revenue growth generated by the company, stock prices can and often do fall. Debt costs aren't all the same and will often vary based on specific market conditions. With that said, it may not always be obvious that unprofitable borrowing is taking place.
It's changes in long-term debt and assets that tend to have the biggest impact on the debt to equity ratio. This owes to the fact that accounts tend to be larger than a business' short-term debt and short-term assets.
Use of the Debt-to-Equity Ratio
The debt-to-equity ratio is an important financial leverage ratio, used by businesses and with stocks around the world. It is used to calculate levered equity beta, which is a measurement of risk associated with price changes in a company or security.
As we work with more formulas and more variables to outline a company's capital structure, the more variance will occur due to errors. The debt of a company increases, and the debt-to-equity ratio increases at the same time. The levered beta increases along with the debt-to-equity ratio.
This has a lot of bearing on whether companies make the call to issue new debt or new equity for their own financing. New debt increases the company's risk and the public's faith in its shares and securities.
Why Debt to Equity Ratio Matters
Debt ratios are a great tool for investors who are trying to find highly utilized companies that take risks at the appropriate times. With this information at hand, investors can compare the company's D/E ratio with the industry average and their competition.
High debt ratios don't even always indicate poor business practices. Debt can accelerate a company's expansion and, generate income during periods of growth or relocation.
Takeaways
When it comes to debt-to-equity ratios for your company, it's important to know what you're looking at once you've calculated yours. Let's take a moment to review:
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The debt-to-equity ratio can be used to compare a company's total debt to its shareholders' equity. This is key to assessing the amount of leverage a company uses.
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Higher leverage ratios may indicate companies or stocks that represent more risk to shareholders.
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It is difficult to compare this ratio in industry groups where the different ideal debt amount is higher or lower than normal. In some industries, it makes more sense to operate using more debt than others.
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Since the risk of long-term debt is different from short-term debt, investors their D/E ratios to focus on long-term debt.
Debt Ratio Modifications
The shareholder's share of your balance sheet comes from the overall value of your assets minus liabilities. This isn't the same as assets minus the liabilities associated with them, however. A common solution to this problem is to modify the debt-to-capital ratio to a long-term version of the same ratio.
Long-term D/E is calculated by comparing the company's total debt, including short and long-term obligations. This is then dividing by shareholder equity.
Short-term debt forms part of any company's overall leverage, but it's not considered a risk because these debts are usually paid off within a year. A company with $500,000 of long-term debt, for example, and $1 million in short-term payables will have a D/E ratio of 1.00. A similar company with $1 million in short-term and $ 500,000 in long-term debt, will have the same D/E ratio of 1.00. But the one with more long-term debt is more of a risk to its shareholders.
It's a fairly common understanding that short-term debt is cheaper than long-term debt. It's less sensitive to interest rate changes. So, if interest rates fall, there's less chance of having to refinance outstanding short-term debt. With long-terms amounts, you'll have to refinance, adding to the overall cost.
Rising interest rates can make long-term debt seem like a better option for many companies. If it can be redeemed by bondholders, however, it could still present a big disadvantage.
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