Ratios are indications and play a vital role in corporate finance. Several financial ratios evaluate the profitability, liquidity, performance, or financial strength of a company or business. The debt to Equity ratio is one of the vital parameters used by financial professionals that indicates a company's financial leverage. It is used to assess how much the company's funds have been derived from shareholder's capital and how much borrowed or raised through a loan; thus, it is essential to understand this ratio if you aim to become a master of finance.
What Is Debt-to-Equity Ratio?
Debt-to-equity is an essential measure to analyze a company's position and financial ability. It reflects the degree to which a firm's financing has been generated through owned funds versus debt. It exhibits the shareholder's capital to pay off its borrowings if it goes bankrupt or decides to close business or liquidate. It is a specific kind of gearing ratio.
How to Calculate The Debt-to-Equity Ratio?
It is simple to calculate the debt-to-equity ratio if you have input data, i.e., the company's debt and equity. Both can be extracted from the company's balance sheet. It is calculated by dividing a business's debt value by the value of its equity.
Debt / Equity = Total Liabilities / Total Shareholders' Equity
Suppose company ABC has equity of $500,000 and liabilities of $1,500,000, then its debt-to-equity ratio will be derived as $1,500,000 divided by $500,000, equal to 3.00. It means the company's debt is three times or thrice of its equity.
Usually, finance professionals consider only long-term debt while calculating the debt-to-equity ratio. A significant chunk of liability and uncertainty related to long-term debt is different from that associated with short-term payables and debt. Although short-term liabilities will also be constituent of the firm's overall leverage position, these will be payoff within a year, thus considered comparatively less risky. So, the modified ratio can be:
Long-Term Debt / Equity = Long-Term Liabilities / Total Shareholders' Equity
Let's continue the above example of company ABC, suppose out of $1,500,000 total debt, the current portion is $1,000,000 and the remaining $500,000 is long-term debt. In contrast, its competitor company XYZ's balance sheet exhibits a long-term liability of $1,000,000 and short-term payables of $500,000. Considering the same amount of equity for both companies, i.e., $500,000, both will have the same D/E ratio, i.e., 3.00. But company XYZ is at high risk due to a high proportion of long-term debt. Both companies' long-term debt to equity ratios is 1.00 and 2.00 for ABC and XYZ companies, respectively.
Let's have a look at the following balance sheet of Apple Inc. as of September 30th, 2017, and calculate the D/E ratio:
We hope that you have calculated the D/E ratio; let's tally our answers. So, the value of debt and equity here are $241,272 and $134,047, respectively (highlighted in red and green). The D/E ratio will be:
Debt / Equity = Total Liabilities / Total Shareholders' Equity = $241,272 / $134,047 = 1.79
The result reflects that Apple had $1.79 of liability for each dollar of equity
In case you don't have the amount of equity, but you have the value of total assets, then the value of equity can be found out as:
Equity = Asset – Liabilities
Where, Liabilities = Long-term debt + Short-term debt
Debt and equity are not only components of a corporation's balance sheet; instead, these belong to individuals' finances. Thus, besides corporate D/E, an individual can also evaluate the D/E of their funds as:
Debt / Equity = Total Personal Liabilities / (Personal Assets − Liabilities)
Moreover, most investors drive this and several other metrics using various software with other analytical tools. Even an excel based financial model can be used to determine financial ratios.
What are the Debt-to-Equity Ratio Implications?
So, now one should understand what the value of D/E reflects; is it good or bad? What is an ideal D/E ratio? There isn't a single perfect Debt to Equity ratio. It is unjustifiable to compare the D/E of different industries because of the difference in debt, industry nature, and even its characteristics. Therefore, it is necessary to compare similar businesses or companies such as US FMCGs or UK's private OMCs, etc., since the D/E benchmark can vary from industry to industry and company to company. For instance, you can compare the D/E ratio of Toyota and Honda. Still, you cannot compare Toyota and Unilever due to the different nature of their businesses or sectors. Similarly, you may not compare the D/E ratio of Coke UK with Coke Pakistan due to the difference in the country's regulations and environment.
A higher D/E ratio or increase in D/E ratio means the business is highly dependent on debt or bank borrowing. Thus, increased risk for business, specifically if debt or interest rates are rising. Whereas, lower D/E ratio or decrease in D/E ratio indicates that organizations rely more on shareholder's funds or equity to finance stock or assets that might cause a reduction in dividend and lead to shareholder's demotivation. Hence, the company must balance both considering its ability to bear the risk and pay interest and shareholder's worth.
The D/E ratio below 1.0 considers a comparatively safer ratio, while the ratio of 2.0 or above is generally considered riskier. However, the D/E of specific sectors usually are higher such as the Banking industry. Remember that too low D/E can also be unfavorable because it means business is not benefiting from debt financing and losing potential opportunities to expand and grow.
Higher debt can raise retained earnings or dividends as a company mainly covering its investment with debt and revenue or growth. Still, high debt comes with high interest or cost of debt that will ultimately affect profits negatively. Debt financing can be favorable for a company if the increase in earnings is more than the increase in the cost of debt; otherwise, it might result in unprofitable borrowing.
You might be wondering that can company has a negative D/E. Can this ratio go below 0? The answer is yes, it can but in rare scenarios. The negative D/E highlights that the company has more liabilities than hazardous assets, which can lead to liquidation or bankruptcy.
Investors often use corporate D/E to evaluate a company's position and worth, potential shareholders to assess the company's financial capability, and banks to analyze the creditworthiness and capacity of the company to pay off debt while generating feasibility or decision regarding loans application of any company.
Similarly, personal D/E plays a vital role in an individual's loan application and facilitates lenders to assess borrowers' ability to make loan payments even in their downtime.It implies that if a person has an excellent D/E ratio, they will be able to pay off their loan from assets or own equity in case if he/she loses his job or temporarily got unemployed. This loan can be either a borrowed prospective mortgage, small business loan, or line of credit.
What is the Difference between the Gearing Ratio and the Debt-to-Equity Ratio?
Gearing refers to financial leverage; it is a broad category comprised of a group of ratios. Gearing and leverage are both interchangeable terms, but gearing can be distinguished from leverage in fundamental analysis. Leverage mainly indicates the value of debt acquired for investments to generate a higher return and profitable growth. In contrast, gearing signifies the amount of debt related to equity or the proportion of borrowing in the company's funds. The difference is similar to the difference between debt and the D/E ratio.
What are the Debt-to-Equity Ratio Limitations?
D/E ratios of all companies are not easily comparable; thus, it is crucial to consider its sector. D/E metric of companies that belong to the same industry or operating in the same sector can be compared. For instance, if the D/E of a company is much higher than the D/E of its competitors, that would indicate issues with its internal management. The external environment is similar for firms operating in the same sector. Moreover, the D/E of few sectors can be relatively high, whereas some industries might have a relatively lower D/E ratio because of the difference in capital requirement and growth rates.
Investors are usually confused with an explanation of debt. For example, preferred stock is a component of equity, but it has many similarities with debt; therefore, the inclusion of preferred stock in equity value might confuse analysts. But it might not be viable to include it in debt, increasing the D/E ratio and displaying a company as riskier. Thus, allocating preferred stock in equity and debt is still confusing and not consistent for all.Let's understand how preferred stock and its reclassification can distort the ratio. Imagine a company with the preferred stock of $200,000, the debt of $600,000 (excluding preferred stock), and equity of $800,000 (excluding preferred stock).
Considering preferred stock as part of liability will give D/E ratio as:
Debt-to-Equity ratio = ($600,000 + $200,000) / $800,000 = 1.00
On contrary, D/E ratio with the inclusion of preferred stock in equity will be:
Debt-to-Equity ratio = $600,000 / ($800,000 + $200,000) = 0.60
D/E ratio excluding the preferred stock will be:
Debt-to-Equity ratio = $600,000 / $800,000 = 0.75
As observed in the above example, the inclusion of preferred stock in debt has increased the ratio, and equity value has decreased it, resulting in an unclear picture of the company's leverage position. Therefore, most analysts exclude it from calculation to avoid distortion and treat it separately using other ratios.