Formula for Debt to equity ratio – What does it tell you?
‘Debt to equity ratio’ is one of the most important indebtedness ratios indicating the extent of financial leverage used by a company. D/E ratio (debt to equity ratio) is calculated to analyze the capital structure risk of a company. It compares the debt level to equity capital, employed by a company to finance its assets.
What is Debt to equity ratio?
‘Debt to equity ratio’ is used to evaluate the proportion between funds raised from outside sources and money contributed by shareholders in the capital structure of a company. Outsiders’ funds represent the total long-term debt taken by a business to finance its growth. It could be in the form of debentures/bonds issued or loans taken from financial institutions.
The higher the value of this ratio, the higher is the level of a company’s dependence on outsiders. On the contrary, the lower the value of this ratio, the lower is the extent of the company’s dependence on outsiders. (Source)
Keynote: D/E ratio shows the relationship between borrowed funds and owners’ capital.
Formula for Debt to equity ratio
D/E ratio is calculated using this formula:
While debt is the aggregate of debentures, secured and unsecured long-term loans owed by a company, equity is the aggregate of paid-up capital and its free reserves.
Debt means all interest-bearing long-term liabilities excluding current liabilities.
Equity means shareholders’ funds i.e. preference share capital, equity share capital, and reserves minus losses & fictitious assets like preliminary expenses.
To measure the long-term solvency of a business, this ratio considers only long-term liabilities in the numerator. For instance, if you owe $75,000 on a loan and $12,000 is due for repair expenses this year, the $12,000 is treated as a current liability, while the other $75,000 is a long-term liability or debt. You include the entire sum of $75,000 in the numerator of the equation for computing the debt to equity ratio.
Another variant of this ratio is when total liabilities (both short-term and long-term) are divided by equity. Here, total debt (i.e., both current & non-current liabilities) is taken into the picture and not merely long-term debt. However, this formula is rarely used and only long-term liabilities are considered since they represent the most important risks. Short-term liabilities are not as risky since they will be paid in a year or less. If we also take current liabilities in the numerator, it may distort the ratio and shift the attention from high-risk bearing liabilities (long-term).
How is the debt to equity ratio calculated?
Imagine a company XYZ Corp. having the following details:
Debentures – $800,000
Creditors – $200,000
Outstanding expenses – $10,000
Long-term loans – $1,600,000
Share capital – $400,000
Reserve funds – $240,000
Preliminary expenses – $40,000
Debt = Debentures + Long term loans = $2,400,000
Equity = Share capital + Reserves – Preliminary expenses = $600,000
The company’s debt to equity ratio would be:
Debt to equity ratio = Debt / Equity = $2,400,000 ÷ $600,000 = 4 times
The ratio is the number of times debt is to equity. Thus, if XYZ Corp.’s ratio is 4, it means that the debt outstanding is 4 times larger than their equity. The ratio is very high and can give an early warning sign to potential investors about the company’s high financial risk.
Note: Fluctuations in the market value of equity can also cause changes in the ratio. Therefore, shareholders’ equity is usually taken on a book value basis.
What should be the ideal ratio?
The ratio is deemed optimal if the shareholders’ funds are equal to long-term debt. However, the acceptable range for this ratio is described as 1 to 2 and long-term borrowed funds should not exceed twice of owners’ funds. Under this range, a company is presumably known to take all the advantages of the debt capital (mainly tax shield) without running into the danger of too much financial distress.
Nevertheless, an ideal ratio may have to be determined separately for different industries. Different ratios may be prevalent in different industries. You must compare yours with the industry average or with the ratios of comparable companies. For example, if your company has a debt to equity ratio of 1.8 compared with the industry average of 1.4, it could mean that your company has greater than the average financial risk when compared to other firms in its industry.
Did you know? The ideal ratio is 0.67:1 when another variant of the formula is used, i.e., total liabilities (both current and non-current) in the numerator instead of only long-term debts.
The debt to equity ratio of a company should also be evaluated from another perspective which is the business stage that the company is currently into. New companies usually tend to have more debt proportion as compared to mature companies since the preliminary years are quite tough. They need some time until they can accumulate enough profits of their own to re-invest into their business. (Source)
In addition, when assessing a company’s health, you should calculate this ratio for a couple of previous years to evaluate the trend. If the ratio has been increasing from year to year, it means the company is being financed by outside parties rather than from its own financial sources. It could be a dangerous trend indicating that the company has been aggressive in funding its growth with the use of debt. Its earnings may be volatile due to excessive interest expenses.
Why should you worry about the D/E ratio?
The ratio is an expression of the soundness of long-term financial policy adopted by a business. A high proportion of debt in the capital structure entails a high level of interest payments and it may put a business in a tight spot now or then. It results in increased vulnerability to business downturns and may impair a company’s repayment capacity. If excessive reliance is placed on outsiders’ funds, it may cause a business to become insolvent because if cash flows become inadequate, a company may face difficulties in payment of interest and repayment of principal. Therefore, it is very important to have a close check on the D/E ratio. Besides this, interest coverage ratios also highlight a business’s capacity to service its interest costs.
Many also believe that debt isn’t always a scary thing. It can be beneficial provided it is utilized for productive purposes like purchasing assets and upgrading processes to boost net profits. (Source)
If a large amount of debt is used to fund increased operations, a company might be able to achieve higher earnings than it would otherwise make without such funding. But, it is only when such earnings increase by a greater amount than the cost of interest that the company & its shareholders would benefit. However, this does not happen in many cases. The cost of debt financing becomes so huge over time that it outweighs the return generated on the debt through business activities (meaning that the rate of return on capital employed is lower than the rate of interest costs payable). This can become too much for a company to handle which may also lead to bankruptcy.
The ratio tells lenders about the margin of safety they enjoy. If a company is too much under the burden of outside liabilities to run its operations, then it increases the risk of lenders in claiming their money repayment. A high ratio signifies less protection for lenders, a low ratio, on the other hand, gives a greater safety cushion to them because they feel that large owners’ funds can help absorb any possible losses of income and capital. This is one of the main reasons why lenders and investors usually use this ratio before putting their money in a business to see if their interests would be protected or not in the event of business failure.
Another purpose of this ratio is to figure out the relative stakes of outsiders and shareholders in a company. This ratio is widely applied in making capital structure decisions such as issuing of stock and/ or debentures. For example, if a firm’s financial leverage is already on the higher side in the composition of its capital structure, it may want to resort to equity or issuance of preferred stock for securing more funds in the future.
Takeaway
When assessing the health of a company, the debt to equity ratio is an important factor to consider. It demonstrates a company’s ability to repay its obligations. A careful balance must be struck between debt and equity because the higher the debt, the higher is the financial risk.
However, the D/E ratio should not be the only deciding factor. It is recommended that one should consider other important metrics also like market statistics, asset and cash position, & profitability ratios to form an overall opinion about a company’s well-being.
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