When measuring the health of a company, it is essential to examine the financial standing of the company. The Debt-equity ratio or risk ratio or gearing is a leverage ratio that can evaluate the company’s financial leverage. It is used to calculate the weight of total debt and financial liabilities against total shareholders’ equity.
What is the Debt to Equity Ratio?
– The debt-to-equity ratio used to measure a company’s ability to repay its obligations.
– The debt/equity ratio shows the health of a company. In case of a higher ratio, the company is getting more financing by borrowing money subjecting to risk if potential debts are too high, which can lead to company bankruptcy during hard times.
– Lenders and investors generally prefer low debt-to-equity ratio because their interests are better protected during a business decline.
– The debt-to-equity (D/E) ratio compares a company’s total liabilities to its shareholder equity and can be used to evaluate how much leverage a company is using.
– Higher leverage ratios tend to indicate a company or stock with higher risk to shareholders.
– However, the D/E ratio is difficult to compare across industry groups, where ideal amounts of debt will vary.
– Investors will often modify the D/E ratio to focus on long-term debt only because the risk of long-term liabilities are different than for short-term debt and payables.
How is Debt-to-equity Ratio Calculated?
To start calculating the debt-to-equity ratio, you have to divide the total debt owed by the company by the shareholders’ equity.
Debt-to-equity ratio = Liabilities / Equity
The liabilities include short term debts, long term debts and fixed payment obligations.
How does a debt to equity ratio work?
A high debt to equity ratio can be associated with increased risk. If the ratio is high, it means that the company is borrowing capital to finance its growth. Lenders and investors often lean towards the companies which have a lower debt to equity ratio.
The debt to equity ratio should be compared to the data from other financial years. If there is a sudden increase in a company’s DE ratio, it can mean that the company has a growth strategy that it is aggressively funding through debt. The ratio should be compared with the average ratios to avoid misinterpretation. Capital intensive companies tend to have a higher DE ratio than service firms.
Limitations of the DE Ratio:
– A debt-to-equity ratio of 1 is considered to be optimal, i.e. liabilities = equity. This ratio is very industry-specific as it depends on the proportion of current and non-current assets. Capital intensive companies will have a higher DE than service companies.
– The maximum acceptable debt-to-equity ratio for more companies is between 1.5-2 or less. For larger companies, a value higher than 2 of the debt-to-equity ratio is acceptable.
– In general, a high debt-to-equity ratio indicates that a company may not be able to generate enough cash to satisfy its debt obligations. However, a low debt-to-equity ratio may also mean that a company is not taking advantage of the increased profits that financial leverage may bring.
Risk of High Debt-to-Equity Ratio:
– If a company’s D/E ratio is very high, any incurred losses will be compounded, and the company may not be able to repay its debt.
– If the DE ratio gets too high, then the cost of borrowing will rapidly increase, as will the cost of equity, and the company’s WACC will get too high, driving down its share price.
Benefits of High Debt-to-Equity Ratio:
– A high debt-equity ratio shows that a firm can efficiently fulfil its debt obligations through the company’s cash flow and is using the leverage to increase equity returns and strategic growth.
– Using more debt raises the company’s return on equity (ROE). The equity account is smaller, and returns on equity are higher if the debt is used instead of equity.
– The cost of debt is often lower than that of equity, and therefore increasing the D/E ratio up to a certain point can lower a firm’s weighted average cost of capital (WACC).
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