Financial ratios are important for readers. The ratios give an insight into the financial stability of the organization and allow investors to make the right investment decision. Every ratio serves a purpose and it is calculated for a specific period of time. Debt and equity are important for any organization. An organization issues equity to investors and borrowers money in the form of debt. Both have their advantages and disadvantages. Excess of anything is not suitable for the growth of the business. Hence, if an organization is heavily dependent on equity or debt, it is not a positive sign.
The debt to equity ratio shows how much debt and equity the business uses to fund the operations. Debt is the long term debt like loans with a maturity period of more than a year. Equity is the shareholders’ equity or the amount that investors in the business own. For small businesses like a sole proprietorship where there is a single owner, the entire investment by the owner is considered as the equity of a shareholder. The ratio can be calculated for every type of business in the industry.
Equity and debt are an essential part of the capital structure of a company and how the company manages its operations. The debt to equity ratio is used as a measure of the risk that a business cannot repay its liabilities. It shows the proportion of equity and debt a company is using to fund the assets. It also shows the amount of equity that is available to fulfill obligations to creditors, if there is a decline in the business.
In case of a decline in the business, the creditors will have to suffer. When a business does not have funds in hand, they continue to pay for liabilities like taxes and bank interest but creditors are not a priority. This means it will be difficult for the creditors to recover their money.
Formula to calculate debt to equity ratio
D/E = Total liabilities/ Shareholders equity
Both the figures can be derived from the balance sheet. A low debt to equity ratio means a low amount of financing by debt versus funding through equity via shareholders. A high ratio indicates that the company has more of its financing by borrowing money. This means that the company is at risk if the debt level is very high. The more the company depends on borrowed money, the higher the risk of bankruptcy, in case the business is hit by difficult times. It happens because minimum payments on loans still have to be paid. Whether the company makes a profit or not, it has to meet the obligations. In a highly leveraged company, when the sustained earnings decline, it could lead to bankruptcy. However, debt can also be helpful in enabling the expansion of the company.
Example of the ratio
Let us consider an example of ABC inc. to calculate the debt to equity ratio. The total liabilities of the company are $241 billion and the total shareholders’ equity is $134 billion.
D/E = 241/134
The result of 1.80 shows that the company had $1.80 of debt for one dollar of equity. It means the company has a higher debt over equity. If you really want to know how the ratio fares, it is best to compare the same with similar companies in the industry. You can also compare the ratio with industry average. Looking at the ratio independently might not give you complete information.
There is no perfect ratio that every organization should strive to achieve. However, 2 is considered an optimal ratio. It shows that the organization has double equity to debt. It means that the organization will be able to meet short term liabilities without any trouble. The ratio should not be more than 2 as it means that the company is heavily equity-oriented.
Importance of Debt to Equity Ratio
The ratio is very useful for investors as it helps identify companies that are highly leveraged. It shows that these companies could pose risks in rough patches. The ratio allows investors to compare the ratio with the industry averages and with other companies to get information about the company’s equity liability relationship. It throws light on the financial stability of the company and helps an investor decide whether the company is worth making an investment in or not.
It is important to note that not all high debt to equity ratios mean poor business. Debt can also help with the expansion of the operations of a company and can generate high income for businesses and shareholders. Before you invest in an organization, it is best to look at the financial statements and compare all the ratios possible.