What is debt-to-equity ratio? | How to interpret D/E ratio? | How to analyze company’s risk using the debt-to-equity ratio?
The debt-to-equity ratio (aka debt to equity ratio or D/E ratio or debt-equity ratio) is one of the most vital metrics and a leverage ratio to analyze the financial stability of a company and its business. Company’s total interest bearing liabilities (debts) is compared with the total of shareholders equity of company. The liabilities may be short term or long term or both. The D/E (debt to equity) ratio is used most widely among investors, analysts and lenders to assess the financial health of company’s business. Strategic and appropriate management of debt can help businesses for growth.
The higher D/E ratio indicates the risks, and it is also impacted by economic downturns. Sometimes higher D/E ratio is considered good if company is generating more net-profit and cashflow with debt than without debt and company’s earnings are more than the cost of debt, as it is necessary to company’s growth. Some people take on account only long-term debts to calculate the D/E ratio.
The value of short-term liabilities, long term liabilities and shareholder’s equity can be found on company’s balance sheet. The investors, lenders and analysts can analyze the D/E ratio for a public listed big multinational company or a small private company. If a company has higher debt than equity then debt to equity ratio will be higher, and it will increase Return on Equity (ROE) on a company’s balance sheet.
However, lower D/E ratio is not always good, as it is considered that either there is no growth in business and industry, or company’s management isn’t taking advantage of leverage to growth. Some companies borrow funds to finance business operation’s needs, as typically cost of debt is lower than that of equity. If a company’s D/E ratio is zero or nearest to zero, it is considered a negative sign by some investors.
The D/E ratio
The debt-equity ratio
The debt to equity ratio
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How to calculate D/E ratio (debt to equity ratio)
D/E ratio (debt-to-equity ratio) formula
To evaluate the value of D/E ratio, the sum of company’s all interest-bearing liabilities (short term and long term) and other fixed financial obligations is divided by the company’s total shareholders’ equity. Company’s liabilities are used as numerator and shareholders’ equity is used as denominator:Debt to Equity Ratio = [(Sum of all interest-bearing liabilities and fixed financial obligations) ÷ Total of shareholders equity]Another form of the above formula is:Debt to Equity Ratio = [(Interest bearing all short-term liabilities + Interest bearing all long-term liabilities + Fixed financial obligations) ÷ Total of shareholders equity]The another and simple form of the above formula is:Debt-to-Equity Ratio = [(Interest bearing all current liabilities + Interest bearing all long-term liabilities + Fixed financial obligations) ÷ Total of shareholders equity]Here, Shareholders Equity = Company’s Total Assets – Company’s Total Liabilities
Let’s say two hypothetical companies “XYZ Limited” and “BCD Limited”. At the end of a financial year, company XYZ Limited had total of interest bearing current financial obligations of INR 1.00 Cr and long-term interest-bearing financial obligations of INR 10.00 Cr. And Company BCD Limited had interest bearing current liabilities of INR 6.00 Cr and interest-bearing long-term liabilities of INR 15.00 Cr. Company XYZ Limited and BCD Limited had the shareholders equity of INR 2.00 Cr and INR 10.00 Cr, respectively. Therefore, according to the aforementioned formula, the D/E ratio for both companies are:D/E ratio for XYZ Limited = [(1.00 Cr + 10.00 Cr) ÷ 2.00 Cr] =11 ÷ 2 = 5.5And D/E ratio for BCD Limited = [(6.00 Cr + 15.00 Cr) ÷ 10.00 Cr] = 21 ÷ 10 = 2.1
The debt-to-equity ratios for both companies are higher than 1; but company XYZ Limited’s D/E ratio is more than twice that of BCD Limited which indicates that company XYZ Limited’s assets is more financed through debt than that of company BCD Limited.However, D/E ratio is just a single metric; and just a single ratio can never tell the complete picture of a company’s financial health, that’s why, it is recommended that never make an investment just rely on one or two ratios. Do in-depth analysis of a company’s business, its industry, business challenges, company’s financials, other ratios and etc. before making an investment decision.
Limitations of debt to equity (D/E) ratio
Industries have different capital need, to wit, oil companies require large capital base to their business operations, but a software service provider company may doesn’t need much capital as capital-intensive industries.Furthermore, this problem is not only with D/E ratio. The same problem is with almost all ratios such as – Return on Equity (ROE) Ratio, Return on Average Assets (ROAA) Ratio etc. That’s why, company analysis should be done with same industry peers. The all-high debt-to-equity ratio (D/E) doesn’t always indicate poor indications.
Some analysts look preferred stocks as debt and include in the numerator part of the D/E ratio calculation formula, but some analysts include the preferred stocks in the denominator part of the D/E ratio calculation formula as equity.
What is an ideal or a good debt-to-equity ratio (D/E ratio)
Generally, the value of D/E ratio higher than 1.5 indicates riskiness. But, there is no pre-set benchmark for D/E ratio, as companies of high capital-intensive industries such as -telecommunications, oil and gas industries may have D/E ratio higher than 1.5, as they need large capital and they borrow money to fund their capital need for business operations.
That’s why, industry’s average should be compared with the ratio value of a company. The debt-to-equity ratio must be compared with the historical trend of a company’s debt-to-equity ratio to gain better understanding which will help to make better investment decision and financial analysis.
If a company’s debt-to-equity ratio is higher than industry average, it indicates that company’s assets are more financed through debt and it is the indication of potential risks. If company’s debt-to-equity ratio is lower than industry average, it indicates that company’s management operating the business with conservative strategies.
A company is considered good if company is generating sufficient cashflow to service debt obligations and its balance sheet is good and debt to equity ratio is below than industry average.
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Is negative debt-to-equity ratio good?
The negative debt to equity ratio (negative D/E ratio) arises when a company’s balance sheet has negative value of shareholders equity. Companies with negative debt to equity ratio are considered riskier, as it is the indication of financial instability. Investors, lenders and analysts see the negative debt to equity ratio as a red flag, they all try to understand the reason behind the negative debt to equity ratio.
Companies may have to face significant problems to borrow fund from lenders with negative debt to equity ratio. If a company consistently operates with the negative debt to equity ratio then company may have to face bankruptcy. Company may also have to face bankruptcy if company’s cashflow isn’t sufficient to service company’s debt and/or cost of debt is higher than the return generated through that debt.
What if high debt-to-equity ratio (D/E ratio)
Generally, a high debt-to-equity ratio indicates risks and if company’s D/E ratio is consistently high, it brings potential troubles for company and sometimes it may lead to bankruptcy. A higher D/E ratio may be one of the reasons of share price decline.
But there are some benefits of high debt-to-equity ratio. Company can finance CAPEX, crucial acquisitions, pre-payment or/and repayment of other financial obligations, projects and other financial needs through debt without equity dilution. Typically, cost of equity is higher than debt’s cost. A low interest debt may be a good source of fund for a company if company generates sufficient net profit and cashflow to service debt obligations.
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Frequently Asked Questions (FAQs)
Q. What is debt to equity ratio?
Ans. The debt to equity ratio (aka debt-to-equity ratio or D/E ratio or debt-equity ratio) is one of the most vital metrics and a leverage ratio to analyze the financial stability of a company and its business. Company’s total interest bearing liabilities (debts) is compared with the total of shareholders equity of company. The liabilities may be short term or long term or both.
Q. What if debt-to-equity ratio is more than 1?
Ans. Generally, a high debt-to-equity ratio (D/E) indicates risks and if company’s D/E ratio is consistently high, it brings potential troubles for company sometimes bankruptcy. A higher D/E ratio may be one of the reasons of share price decline, but there are some benefits of high debt-to-equity ratio. Company can finance CAPEX, crucial acquisitions, pre-payment or/and repayment of other financial obligations, projects and other financial needs through debt without equity dilution. Typically, cost of equity is higher than debt’s cost. A low interest debt may be a good source of fund for a company if company generates sufficient net profit and cashflow to service debt obligations.
Q. What is a safe range for debt-to-equity ratio?
Ans. There is no pre-set benchmark for D/E ratio, as capital-intensive industries such as – telecommunications, oil and gas industries may have higher D/E ratio, as they need large capital to fund their business operations. That’s why, industry’s average and D/E ratio of other companies of same industry should be compared with the D/E ratio value of a company.
Q. What is negative debt to equity ratio?
Ans. The negative debt-to-equity ratio is a red flag for a company; it arises when company’s shareholders equity (aka stockholders’ equity) is negative.
Q. What happens if a company has more debt than equity?
Ans. The capital structure and fund needs vary industry to industry, as it depends on business nature. A company with higher D/E ratio is considered good if company is growing using the debt amount and debt’s cost is lower than company’s earnings and company is generating sufficient earnings and cashflow to service its debt.