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What is Debt to Equity Ratio?

The debt to equity ratio compares a company’s total debt to its total equity to determine the riskiness of its financial structure. The ratio displays the proportions of debt and equity financing used by a company. Lenders and creditors keep a careful eye on it since it can signal when a company is so in debt that it can’t satisfy its obligations. Whatever the cause for debt consumption, if business cash flows are insufficient to fulfils recurring debt payments, the result can be disastrous.

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Lenders are concerned because their loans may not be repaid. For the same reason, suppliers are concerned about the ratio. A lender’s interests can be protected by imposing collateral requirements or restrictive covenants.  On the other hand, suppliers typically extend credit with less restrictive terms. Hence, these suppliers suffer more if a company fails to make its payment obligations.

When a company’s debt to equity ratio is high, it has imposed a significant block of fixed costs in the form of interest expenditure, which raises the breakeven point. To break this cycle, the company needs to generate more revenue by selling more goods or services. The revenue and net income will be regular and predictable without a significant interest expense.

How to Calculate Debt Equity Ratio?

The formula for the Debt to Equity Ratio is:

Debt to Equity Ratio = Total Liabilities / Shareholder’s Equity

Where,

Total Liabilities = Short Term Liabilities + Long Term Liabilities

Shareholder’s Equity = Total Assets – Total Liabilities or Share Capital + Retained Earnings + Other Reserves

The following illustration demonstrates how to calculate Debt to Equity Ratio.

Interpretation of Debt to Equity Ratio

The debt-to-equity ratio compares the value of a company’s net assets to its debt. A high D/E ratio is frequently associated with high risk. It indicates that a company has used debt to fund its expansion.

If a company uses a large amount of debt to fund growth, it may be able to make higher earnings than it would have otherwise. Shareholders can expect to benefit if leverage increases earnings by more than the cost of debt (interest). Share values may fall if the cost of debt financing outweighs the improved income provided. The cost of debt can fluctuate depending on market conditions. Unprofitable borrowing may thus go undetected at first.

The long-term debt and assets are larger than short-term debt and assets. They have the strongest effect on the D/E ratio. Other measures can be used by investors to assess a company’s short-term leverage and its capacity to meet short-term liabilities. Moreover, the calculation of the Debt To Equity Ratio is often modified by the analysts. They do so to focus on long term liabilities. The long term liabilities have a higher impact on shareholder’s value and survival..

Good Debt to Equity Ratio

A ratio of less than one is accepted by analysts. What defines a good debt to equity ratio, on the other hand, is dependent on a variety of things. If a company has a history of continuous cash flows, for example, it can likely sustain a much higher percentage. A new business without a solid business plan, on the other hand, may not want to take on any debt at all because it may not be able to repay it.

Businesses in industries where sales are pretty assured (such as telecommunication) may probably afford to maintain a fairly high debt to equity ratio. This is because their cash flows are so consistent. In contrast, a company in a highly competitive industry with short product cycles will mostly opt for a lower debt-to-equity ratio. This is due to the fact that in seasonal businesses the stream of cash inflows are not predictable.

Negative D/E Ratio

When a company’s D/E ratio is negative, it signifies the company has negative shareholder equity. To put it another way, the company has more liabilities than assets. This would indicate insolvency.

Limitations of Using Debt to Equity Ratio

• In some cases, the ratio can be deceiving. If a company’s equity comprises a significant proportion of preference shares then these shareholders will mandatorily receive preference dividends. Hence, the company will require a significant dividend payment. This would reduce the amount of residual cash flow available to pay debt. In a way, this preference share has debt-like features rather than equity.
• Another concern is that the ratio does not indicate whether or not debt repayment is forthcoming. It could happen soon or it could happen so far in the future that it isn’t worth thinking about. A high debt-to-equity ratio might not be a matter of worry if the due date is so far in the future.
• This ratio is valuable for determining the riskiness of an entity’s financial structure. However, it does not provide information on a company’s ability to repay its current loans. The  current ratio is more relevant for that information. It compares current assets to current liabilities. The quick ratio is a version that eliminates inventory from current assets. As a result, it is wise to combine the debt-to-equity ratio with other ratios that concentrate at short-term liquidity.
• It is critical to consider the industry in which the company operates while using this ratio. Different businesses have varying capital demands and growth rates. One industry may have a comparatively high D/E ratio while another has a relatively low D/E ratio.

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