Definition of Debt to Equity Ratio
Debt to Equity Ratio is the metric which shows us the proportion of debt as a percentage of equity in the total capital of the company, thereby bringing to the fore the nature of the current capital structure employed by the company and thus letting the internal and external stakeholders know how well it is performing on the targeted capital structure criteria.
Explanation
It is a complete balance sheet ratio as both the numerator and the denominator come from it, however, at times, the ratio is also calculated using the market value of the debt and equity if these trade on the stock exchange.
There are several variations in calculating the numerator and the denominator of the formula as some analysts include preferred shares to the equity component, some may remove the current portion of the debt as it is a current liability while some others may use all the items on the liability side of the balance sheet except the shareholder’s equity in the debt portion, including the current liabilities.
Therefore it is important to read the fine print of what has gone into each input while analyzing a published debt to equity ratio
Formula
The formula for calculating the Debt to Equity Ratio is as follows:
Example of Debt to Equity Ratio
Suppose a company has a long term debt of $30 million, Equity of $20million, Assets of $60 million. This would imply that the liabilities other than debt are 60-20-30 = $10 million
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Now if we need to find the Debt to Equity ratio, some analysts may only use the given amount of long term debt that is, the $30 million, while some might also include the liabilities other than debt and therefore use $40 million as debt.
Solution:
Debt to Equity Ratio is calculated using the formula given below
Debt to Equity Ratio = Debt/Equity
- = 30/20
- = 1.5
OR
Debt to Equity Ratio = (Debt + Liabilities)/Equity
- = (30 + 10)/20
- = 40/20
- = 2
Therefore an investor needs to always read the calculation methodology before comparing the ratio for two companies and then only decide which security is a better fit.
Importance
Some of the importance are given below:
- Indicative of Financial Position: The ratio implies how much debt a company has, per unit of equity. As Equity comprises the capital owned by the shareholders while debt is borrowed from third parties, this ratio can tell how well positioned a company is in meeting its financial obligations by way of equity funds. Therefore a ratio of less than 1 would mean that the company has a greater proportion of owned capital in comparison to borrowed one and the opposite is true when it comes to a ratio greater than 1
- Target Capital Structure Metric: Most companies have built up their strategies of targeted capital structure and work towards achieve the same, therefore an over the time observation of this ratio is required to analyze how well is the company meeting this criterion and how long a way it still needs to cover
- Investment Research Metric: When the market value numbers are used as the inputs to the ratio, the movement in share and debt prices indicate how volatile the company stock is and acts as a starting point of whether the company securities are a good fit into the investment portfolio
Difference between Debt to Equity Ratio and Gearing Ratio
Gearing ratio is a classification of several ratios while the Debt to Equity ratio is a subset of the same. Therefore Gearing Ratio is a broader term as compared to the Debt to Equity ratio. The constituents of gearing ratio are Equity Ratio, Debt to Capital Ratio, Debt to Equity Ratio, Debt Service Ratio & Debt to Shareholder’s fund’s Ratio.
Benefits
Some of the benefits are given below:
- Indicative of residual profit: The ratio tells us how much debt is present in comparison to the amount of equity. Therefore the ratio can be used to draw a conclusion about how much profit will be available for equity holders because they only have the residual claim over the profits of the company.
- Indicative of Risk: Generally a high ratio implies greater risk as the interest expense associated with debt is also high for a high debt company and it is a mandatory outlay even when the company is not making profits. Therefore it is riskier to invest in such companies. By analysis of this ratio, the investor can decide whether the security fit within his risk constraints.
Limitations
Some of the limitations are:
- Multiple variants: The ratio has several variations to it as explained earlier and therefore, it is harder to draw comparisons without adjusting the ratios of the two companies and bringing them to the same page. Some such information might not be easily available in the financial statements and therefore might need deeper research
- Volatile inputs: The ratio computed on the market value for those companies which have a volatile share price or debt price might not make much sense and might require smoothening, which is an estimated procedure and therefore may not be highly accurate.
- Industry Specific: The ratio varies from one industry to another as various industries have different needs for capital. Those Industries which require a huge investment in fixed assets, generally have a higher debt to equity ratio because initially, the quantum required might be too huge for a company to raise a through equity. Therefore the ratio doesn’t help in inter-industry comparison
Conclusion
So now we know that Debt to Equity Ratio is a measure of the amount of leverage a company has and acts as a comparison tool in the process of investment research. A higher ratio implies the level of risk a company has and therefore it helps the investor in deciding whether or not an investment is worth investing.
There are many variants of the ratio and therefore the investor needs to be careful while comparing it and understand properly what are the constituents of the inputs of the ratio before blindly giving the edge to the company with a lower ratio.
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