Investing in or growing a business requires a grasp of the definitions and correlations between different financial variables. When it comes to getting an overview of the financial health of a business, it is crucial to understand the debt-to-equity ratio (D/E ratio).
The D/E ratio shows a company's total debt compared to its assets, calculated by dividing the total debt by the shareholder equity (the assets of the business). The ratio offers insight into how the company finances its daily operations, whether by borrowing or using the available assets. For example, a debt-to-equity ratio of 1.5 means that for every $1.5 the company owes, it has $1 in shareholder equity. The ratio is highly contextual, depending on the business and niche, but for most companies, a ratio of 2.0 to 2.5 is considered robust and attractive to lenders and investors.
The total debt encompasses the company's short-term, long-term, and fixed payments incurred in a normal business cycle. The company's debt schedule indicates the primary differences of the three parts of the total debt.
To calculate the D/E, one requires the company's total assets and liabilities, usually found in the balance sheet. From the two, calculate the shareholder equity by subtracting the total liabilities from the total assets. The D/E ratio is the total liabilities divided by the assets. While the calculation is straightforward for most companies, some structures have variables like pension plans, intangible assets, and retained finances that may distort the D/E ratio or make it difficult to calculate. In this instance, the auditors decide on the modifications to make in the formula, primarily regarding what constitutes the liabilities.
A high ratio implies excessive reliance on debt for operations and, therefore, more risk for investors and lending institutions. It also means that the company faces recurring debt repayment, interest rate expenses, and the risk of asset possession in case of default. All factors are likely to discourage both investors and lenders. A constant state of debt financing can also negatively affect the value of the company’s shares, thus lowering the company's market capitalization.
Nevertheless, some forms of debt can be beneficial. Companies can pay off the short-term debt in a year or less, offering less risk and presenting leverage. Short-term debts are also less sensitive to changing interest rates than long-term debt. In the latter, a shift results in higher interest rates over a long time, thus increasing the ratio, especially after a default. A high ratio may, however, show the ability of a company to service its debts, an attractive prospect for investors, as it indicates a healthy cash flow.
Conversely, if the ratio is too high, it may compound the losses whereby a company loss or expense cannot be resolved before another occurs. To prospective or impatient investors, the inability to achieve stability due to overlapping or compounded losses and the inability to service loans can be unappealing. The company also survives at the mercy of market conditions and interest rates-too high a shift increases the interest expenses or extends the duration of payment, suspending the company in a perpetual state of debt financing.
While the D/E ratio enjoys widespread use as a measure of financial health, limitations abound, depending on the industry to which the ratio applies. Depending on the niches, companies require different capital needs, liability bases, and growth rates, so a general ratio is inapplicable. Examples of industries that thrive on high ratios include utility stocks, consumer staples, and other companies with steady rates of return or those working in highly regulated environments
