Having difficulty making investment decisions with respect to the debt-equity ratio? This article will help to decide what is a good debt to equity ratio for you and how you can interpret these ratios based on different situations.
To grow a business one needs investment capital. When companies are scaling, they need money to launch products, recruit employees, help customers, and expand operations. There are several ways to raise capital, and each will have a different impact on your company and the rate at which you grow.
The most common way to raise capital is through either equity or debt. But what do each of these requires? And how do they help your business’ financial position? Well, you’re in luck, because in this article we’ll take a look at debt to equity ratio, what is a good debt to equity ratio, how to improve the D/E ratio, and its analysis.
What is the debt to equity ratio?
Used in corporate and personal finances, the debt-to-equity ratio refers to a financial measure that assesses your company’s financial leverage. In other words, it lets you decide how much a company finances its operations through debt compared to owned funds. It’s also referred to as the personal debt-to-equity ratio when used with personal financial statements.
The debt-to-equity ratio permits you to determine if there’s enough shareholder equity to pay off debts if your company were to face a drop in profits. Investors have a tendency to modify the ratio to center on long-term debt since risks change when you look beyond the short-term, or they use other formulas to ascertain a company’s short-term leverage.
Though the debt-to-equity ratio provides you with an idea of a company’s financial leverage, remember that the calculation risks changes incurred from earnings, losses, and other adjustments. Because of this, it’s crucial to conduct further research to come to a fairer conclusion. It’s also worth noting that a company’s debt-to-equity ratio varies across industries since amounts of debt vary by sector.
Debt to Equity Ratio Example
Let’s say an internet company is applying for funding and needs to calculate its debt to equity ratio. Its total liabilities are $300,000 and shareholders’ equity is $250,000.
Here’s what the debt to equity ratio would look like for the company:
Debt to equity ratio = 300,000 / 250,000
Debt to equity ratio = 1.2
With a debt to equity ratio of 1.2, investing is less risky for the lenders because the business isn’t highly leveraged or primarily financed with debt.
What is a good debt to equity ratio?
A good debt to equity ratio is around 1 to 1.5. However, the ideal debt to equity ratio will change depending on the industry because some industries use more debt financing than others. Capital-intensive industries like the financial and manufacturing industries often have higher ratios that can be greater than 2.
A high debt to equity ratio suggests a business uses debt to finance its growth. Companies that invest large amounts of money in assets and operations (capital intensive companies) often have a higher debt to equity ratio. For lenders and investors, a high ratio implies a riskier investment because the business might not be able to generate enough money to repay its debts.
If a debt to equity ratio is lower — closer to zero — this often means the business hasn’t relied on borrowing to finance operations. Investors are not likely to invest in a company with a very low ratio because the business isn’t recognizing the potential profit or value it could gain by borrowing and increasing operations.
How to improve debt-to-equity ratio?
Companies can take steps to cut and improve their debt-to-capital ratios. Among the approaches that can be used are increasing profitability, better management of inventory, and restructuring of debt. The methods used to lower the ratio are best used in tandem with each other and, if the market timing is appropriate, used in combination with a rise in the pricing of their goods or services.
The most logical step a company can take to improve its debt-to-capital ratio is that of increasing sales revenues and hopefully profits. This can be attained by raising prices, increasing sales, or reducing costs. The extra cash produced can then be used to pay off existing debt.
Another measure that can be taken to reduce the debt-to-capital ratio is more effective inventory management. Inventory can take up a very substantial amount of a company’s working capital. Maintaining unnecessarily high levels of inventory beyond what is required to fill customer orders in a timely manner is a waste of cash flow. Companies can analyze the day’s sales of inventory (DSI) ratio, part of the cash conversion cycle (CCC), to ascertain how efficiently inventory is being managed.
Restructuring debt offers another way to reduce or improve the debt-to-capital ratio. If a company is largely paying relatively high-interest rates on its loans, and current interest rates are considerably lower, the company can seek to refinance its existing debt. This will lower both interest expenses and monthly payments, enhancing the company’s bottom-line profitability and its cash flow and increasing its stores of capital. This is a common and straightforward method used to attain better terms for the company and their outflows.
Why does the average debt to equity ratio vary by industry?
One of the main reasons why D/E ratios vary is the capital-intensive nature of the industry. Capital-intensive industries, such as oil and gas refining or telecommunications, need substantial financial resources and large amounts of money to produce goods or services.
For example, the telecommunications industry has to make very significant investments in infrastructure, installing thousands of miles of cables to provide customers with service. Beyond that initial capital expenditure, necessary maintenance, upgrades, and expansion of service areas require additional major capital expenditures. Industries such as telecommunications or utilities need a company to make a large financial commitment before delivering its first good or service and making any revenue.
If a company is in decline then a high D/E ratio is of concern, on the contrary, if a company is on the rise, a high D/E ratio might be required for growth.
Another reason why D/E ratios vary is based upon whether the nature of the business can handle a high level of debt. For example, utility companies bring in a stable amount of income; demand for their services remains relatively constant irrespective of overall economic conditions. Also, most public utilities operate as virtual monopolies in the regions where they do business; so, they do not have to fret about being cut out of the marketplace by a competitor.
Such companies can carry larger amounts of debt with less genuine risk exposure than a business with revenues that are more exposed to fluctuation in accord with the overall health of the economy.
Debt-to-equity ratio high or low
High debt-to-equity ratio
The financial sector overall has one of the highest D/E ratios; however, looked at as a measure of financial risk exposure, this can be deceiving. Borrowed money is a bank’s stock in trade. Banks borrow large amounts of money to loan out large amounts of money, and they typically work with a high degree of financial leverage. D/E ratios higher than 2 are common for financial institutions.
Low debt to equity ratio
With low debt-to-debt ratios, this indicates less financing through debtors than through shareholders. A higher rate would indicate the company is borrowing more to finance its operation. Too high a debt level and the company is exposed to various risks, chief of which is the risk of bankruptcy when business performance declines.
Even when a company isn’t making enough of a profit to meet its various obligations, minimum payments for its loans still need to be paid. For leveraged companies, where loans finance operations, a consistent loss in earnings can cause problems.
Your debt ratio is calculated by dividing your total debt by your total overall capital. All elements are reported on the balance sheet, hence the debt ratio is also commonly referred to as a balance sheet ratio. All of which is fair and well, but is it best to keep your debt to equity ratio high or low?
Other industries that commonly show a relatively higher ratio are capital-intensive industries, such as the airline industry or large manufacturing companies, which utilize a high level of debt financing as a common practice.
Advantages of a high D/E ratio
Despite the worrying sounding name, higher debt ratios can in fact be beneficial. Companies can deal with debt liabilities through any given set of cash flows and leverage in order to boost their returns on the stock.
By using debt instead of equity, your equity account will also be smaller than otherwise. Being compelled to work at this level also means a higher return on equity, overall. Debt costs are also lower than the capital costs. So raising the D/E ratio may lower weighted average capital costs (WACC) for your company.
Disadvantages of high D/E ratio
If you haven’t observed yet, the truth of the matter is there’s no such thing as an “ideal debt-equity ratio” for all businesses. Everybody is unique, and some operations do better with a high number than others.
There were always going to be some drawbacks to a high D/E ratio, however. If your company’s ratio is far too high, losses can occur, and your business may not be ready to cope with the resultant debt. When your debt ratio becomes too high, it also pushes your borrowing costs up. Not only this, but stock prices are also likely to plummet.
Negative debt to equity ratio
A negative debt to equity ratio arises when a company has interest rates on its debts that are greater than the return on investment. Negative debt to equity ratio can also be a consequence of a company that has a negative net worth. Companies that suffer a negative debt to equity ratio may be seen as risky to analysts, lenders, and investors because this debt signifies financial instability.
A company can experience a negative debt to equity ratio for several reasons, including:
- Taking on additional debt to cover losses instead of issuing shareholder equity.
- Expensing intangible assets, such as trademarks, that exceed pre-existing shareholder equity values.
- Making large dividend payments that surpass shareholders’ equity.
- Experiencing financial loss in periods following large dividend payments.
When any of these situations occur, they could suggest a sign of financial trouble to shareholders, investors, and creditors.
Debt equity ratio calculator
Debt ratios are a useful tool for investors who are trying to find highly utilized companies that take risks at the appropriate times. With this information at hand, investors can compare the company’s D/E ratio with the industry average and their competition.
High debt ratios don’t even always imply poor business practices. Debt can speed up a
company’s expansion and, generate income during periods of growth or relocation.
So, to make it easier for you there are several debt-equity ratio calculators that you can use to make informed investment decisions quickly.
Benefits of a debt-to-equity ratio
Using the debt-to-equity ratio comes with numerous benefits from a financial point of view. Here are some of the benefits of using the debt-to-equity ratio:
- It lets investors analyze a company’s financial health and its low or high liquidity.
- It helps understand shareholder’s earnings. This means it lets you decide if the company has a high or low debt, which influences profits. When profit decreases, so do dividends, which are distributed to shareholders.
- The ratio helps lenders and creditors determine if they can rely on small businesses in regards to their loan applications. It also lets them know if these small businesses make regular installment payments.
- It helps management teams determine the market competition and what’s needed to improve the ideal debt-to-equity ratio.
The bottom line is that If you’re assessing potential investment opportunities, it’s worth taking a look at a company’s debt-to-equity ratio. It’s not the only piece of research worth doing, but it does provide important information about how much risk and leverage the company has taken on. To know whether it’s high or low, you should compare it to the average debt-to-equity ratio by industry. You can also use the metric to assess financial risk in your own household.