Debt is often seen as a red flag by investors. But in a business context, debt, if smartly leveraged, can be an excellent source of funding. Investors and business analysts want companies to use their debt effectively. But how can the utility of debt be measured? This is where the debt-to-equity ratio comes into the picture.
Let’s take a deeper look at the debt-to-equity ratio, its formula, benefits, drawbacks and more.
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What is the debt-to-equity ratio?
The Debt-to-Equity ratio (D/E ratio) is a financial ratio used to evaluate a company’s financial leverage. It indicates the extent to which a company is reliant on debt for its operations.
In other words, this ratio indicates how well the company uses its debt to finance its business and can further help determine its ability to pay back its liabilities. In a nutshell, it indicates the overall financial health of a company.
It is crucial to consider the company’s industry when using the D/E ratio since different industries have different capital needs and growth rates.
Return on equity: Highlights
- The debt-to-equity ratio is a key financial ratio that shows how much of a company’s assets are financed by debt vs shareholders’ equity.
- The D/E ratio is important because it can give insights into a company’s financial health and help creditors and investors assess risk.
- A high debt-to-equity ratio is considered risky, while a low debt-to-equity ratio implies that the company is not majorly relying on debt financing to grow and expand its business operations.
- The debt-to-equity ratio varies from industry to industry.
Debt-to-equity ratio interpretation
The debt-to-equity ratio enables firms to analyse whether they are using more debt or equity to run their business operations. It is a straightforward ratio that depicts how a company has been raising capital for its functioning.
A high debt-to-equity ratio usually indicates that the company is taking on higher risks by borrowing money from the market to finance its business operations. On the other hand, a low debt-to-equity ratio can imply that the business is primarily relying on equity to finance its business, which could be a positive sign since it is borrowing less from the market.
The metric is considered important as it indicates a company’s stability and can help predict its growth.
How to calculate the debt-to-equity ratio?
The debt-to-equity ratio formula is given by the total liabilities divided by the shareholders’ equity, where the total liability consists of all the long-term and short-term debts, as indicated here:
D/E ratio = Total debt / Total shareholders’ equity
Debt-to-equity ratio formula example: If a company’s total debt as per the balance sheet is Rs. 20 lakh and the shareholders’ equity is Rs. 24 lakh, then the debt-to-equity ratio will be calculated as
D/E ratio = 20/24
= 0.833
So the debt-to-equity ratio of this store is 0.833, which means that for every rupee in equity, the company has 83 paise in leverage.
Benefits of a high debt-to-equity ratio
- A high debt-to-equity ratio means a company can generate enough cash flow to cover its debt payments and invest in growth initiatives. This is a positive sign because it indicates that the company can leverage its existing assets to generate more value for shareholders.
- A high D/E ratio means that a firm has more debt than equity, which can help to lower the Weighted Average Cost of Capital (WACC). This is because the cost of debt is usually lower than the cost of equity.
- A high debt-to-equity ratio can help increase the Return on Equity (ROE). This is because when a company has more debt, it can help it leverage its assets and potentially make more profits.
Drawbacks of a high debt-to-equity ratio
- The risks of defaulting on repayment obligations increasing could lead to serious financial problems for borrowers, including high-interest rates, late fees, and damage to their credit score.
- If a company’s current debt level is high, it can be challenging to obtain additional financing.
- A high debt-to-equity ratio might suggest that owners’ equity stakes in a business have decreased in value.
What is a good debt-to-equity ratio?
A D/E ratio below 1 would be relatively safe, while a D/E ratio of 2 and above would be considered risky. An ideal debt-to-equity ratio is 1 to 1.5.
In the end, a good debt-to-equity ratio will depend on the sector and the nature of the business. For instance, the financial sector may have a higher debt-to-equity ratio than others.
However, ideally, the ratio should not be more than 2. This can mean that the company is borrowing excessively.
Debt-to-equity ratio calculator
Debt-to-equity ratio calculators are simple online tools that can be used to determine the value of the D/E ratio. All one needs to do is enter the debt and shareholders’ equity values.
In an instant, the tool would generate the debt-to-equity ratio.
What is a negative debt-to-equity ratio?
A negative debt-to-equity ratio indicates that the company has more liabilities than assets. The company would be seen as extremely risky and or at risk of bankruptcy.
Long-term debt-to-equity ratio
The long-term debt-to-equity ratio measures how much of a business’s assets are financed by long-term debt. The long-term debt-to-equity ratio is calculated by dividing the long-term liabilities by the shareholders’ equity.
Long-term debt-to-equity ratio formula = Long-term debt / Shareholders’ equity
What’s next for companies with a good debt-to-equity ratio?
Companies with a good debt-to-equity ratio should typically fall within their respective industries’ common D/E ratio range. Besides its debt-to-equity ratio and long-term growth, a company should focus on maintaining a positive balance in its financing from debt and equity.
Conclusion
The debt-to-equity ratio is a financial ratio that measures the level of debt against equities. An ideal debt-to-equity ratio would be between 1 and 1.5, although depending on the industry, it can be up to 2 also. A debt-to-equity ratio higher than 2 can be considered risky in many industries. A negative debt-to-equity ratio would indicate that the company has more liabilities than its assets. Therefore, a company with the right vision should smartly use debt financing to fund, grow and expand its business operations.
