Debt to equity ratio
/What is the Debt to Equity Ratio?
The debt to equity ratio measures the riskiness of a company's financial structure by comparing its total debt to its total equity. The ratio reveals the relative proportions of debt and equity financing that a business employs. It is closely monitored by lenders and creditors, since it can provide early warning that an organization is so overwhelmed by debt that it is unable to meet its payment obligations. This is also a funding issue. For example, the owners of a business may not want to contribute any more cash to the company, so they acquire more debt to address the cash shortfall. Or, a company may use debt to buy back shares, thereby increasing the return on investment to the remaining shareholders.
Whatever the reason for debt usage, the outcome can be catastrophic if corporate cash flows are not sufficient to make ongoing debt payments. This is a concern to lenders, whose loans may not be paid back. Suppliers are concerned about the ratio for the same reason. A lender can protect its interests by imposing collateral requirements or restrictive covenants; suppliers usually offer credit with less restrictive terms, and so can suffer more if a company is unable to meet its payment obligations to them.
When a business has a high debt to equity ratio, it has imposed on itself a large block of fixed cost in the form of interest expense, which increases its breakeven point. This situation means that it takes more sales for the firm to earn a profit, so that its earnings will be more volatile than would have been the case without the debt.
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How to Calculate the Debt to Equity Ratio
To calculate the debt to equity ratio, simply divide total debt by total equity. In this calculation, the debt figure should include the residual obligation amount of all leases. The formula is as follows:
(Long-term debt + Short-term debt + Leases) ÷ Equity = Debt to equity ratio
Other obligations to include in the debt part of this calculation are notes payable, bonds payable, and the drawn-down portion of a line of credit. A variation is to add all fixed payment obligations to the numerator of the calculation, on the grounds that these payments are akin to debt. For example, the remaining rent payments due on a lease could be included in the numerator. The numerator does not include accounts payable, accrued expenses, dividends payable, or deferred revenues.
Alternatives to the Debt to Equity Ratio
While the debt to equity ratio is useful for measuring the riskiness of an entity’s financial structure, it provides no insights into the ability of a business to repay its immediate debts. For that information, it is more useful to calculate a firm’s current ratio, which compares current assets to current liabilities. A variation is the quick ratio, which excludes inventory from current assets. Thus, it makes sense to combine the calculation of the debt to equity ratio with additional analyses that are used to examine liquidity over the short term.
Example of the Debt to Equity Ratio
As an example of the debt to equity ratio, New Centurion Corporation has accumulated a significant amount of debt while acquiring several competing providers of Latin text translations. New Centurion's existing debt covenants stipulate that it cannot go beyond a debt to equity ratio of 2:1. Its latest planned acquisition will cost $10 million. New Centurion's current level of equity is $50 million, and its current level of debt is $91 million. Given this information, the proposed acquisition will result in the following debt to equity ratio:
($91 Million existing debt + $10 Million proposed debt) ÷ $50 Million equity
= 2.02:1 Debt to equity ratio
The ratio exceeds the existing covenant, so New Centurion cannot use this form of financing to complete the proposed acquisition. However, it could attempt to alter the terms of the deal to drop the projected ratio below the 2:1 level.
Problems with the Debt to Equity Ratio
While the debt to equity can provide insights into a company's risk and financial structure, there are several problems and limitations with it, which are as follows:
Book value vs. market value. The ratio uses the book value of equity (from the balance sheet) instead of its market value (current stock price). Book value can be outdated or irrelevant, especially for growing companies. Therefore, companies with a low book value of equity could appear over-leveraged, even if their market value is high.
Industry comparison problems. Different industries have varying capital structures. For example, capital-intensive industries (e.g., utilities, manufacturing) naturally have higher debt-to-equity ratios compared to technology or service industries. Therefore, comparing the debt-to-equity ratio of companies across industries can lead to misleading conclusions.
Accounting policies can skew results. Accounting methods for valuing assets, liabilities, and equity can vary (e.g., depreciation, inventory valuation). These accounting differences can distort the ratio.
Does not measure cash flow. The debt-to-equity ratio does not consider a company’s cash flow or its ability to repay debt. A high ratio might not be problematic for a company with strong cash generation. Conversely, companies with weak cash flows might struggle to service debt, despite having a “healthy” debt-to-equity ratio.
Static snapshot of financial position. The ratio reflects a company’s financial structure at a specific point in time. It does not capture fluctuations or trends over time. Thus, a company could have temporarily high or low debt and equity, making the ratio misleading.
No long-term vs. short-term differentiation. The ratio treats all debt equally, regardless of maturity. Long-term and short-term debts have different risks and cost implications. Therefore, a company with significant short-term debt (which is riskier) might appear similar to one with safer, long-term financing.
Does not include off-balance sheet liabilities. Some debts (e.g., operating leases, pension liabilities) may not appear on the balance sheet but still represent obligations. Therefore, the ratio may underestimate the true level of financial risk.
Near-zero equity issue. If a company has negative or near-zero equity (liabilities exceed assets), the debt-to-equity ratio becomes meaningless or even undefined. This limits its use for financially distressed companies.
Leverage level depends on growth. High leverage might be acceptable for fast-growing companies (where profits justify borrowing) but dangerous for slow-growth companies.
Ignores the cost of debt. The ratio does not consider the cost of debt or the interest rates associated with borrowing. Thus, two companies with similar ratios might face very different financial risks based on their borrowing costs.
What is a Good Debt to Equity Ratio?
Generally, a debt to equity ratio of no high than 1.0 is considered to be reasonable. However, what constitutes a good debt to equity ratio depends on a number of factors. For example, if a company has a history of consistent cash flows, then it can probably sustain a much higher ratio, since it can depend on having enough cash to make the related debt payments. Conversely, a new business without a firm business plan might not want to take on any debt at all, since it may not be in a position to pay it off.
Businesses located in industries where sales are reasonably assured (such as an electricity provider) will probably have such consistent cash flows that they can afford to maintain a fairly high debt to equity ratio. Conversely, a business located in a highly competitive market where product cycles are short would be well advised to maintain a very low debt to equity ratio, since its cash flows are so uncertain.