Debt Equity Ratio

What is the Debt to Equity Ratio?

Debt to Equity (D/E) is a vital financial measure that shows the ratio of debt owed by a company compared to the equity value of the company. It is often used to evaluate the amount of leverage a company has taken. This ratio also reveals the amount to which the company's shareholders' equity can pay off its outstanding liabilities. While this metric does reveal much to investors, it's important to remember that this ratio is just one of many pieces to reveal the full picture of an asset's financial health.

At a high level, the formula for D/E is:

  • Debt to Equity = Total Liabilities / Shareholders Equity

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Debt to Equity Calculation Example

Let's examine two companies, Jim's Lemonade Shop and Sarah's Bakery. Both owners are interested in getting a loan for their company with a bank. One of the tools the bank may use to measure the risk between the companies is the Debt to Equity Ratio. Here is an example of a D/E calculation using small numbers:

Jim's Lemonade Shop has $200 in assets and $150 in liabilities.

  • Using the fundamental Accounting formula that: Assets = Liabilities + Shareholders' Equity, we can calculate that Jim's Lemonade Shop has $50 in Equity.
    • $200 = $150 + Shareholders' Equity
    • Shareholders' Equity = $200 (Assets) - $150 (Liabilities)
  • Using the D/E ratio formula listed above, the calculation would look like this:
    • D/E = $150 (Liabilities) / $50 (Equity)
    • D/E = 3.0

Sarah's Bakery has $200 in assets and $20 in liabilities.

  • Using the fundamental Accounting formula that: Assets = Liabilities + Shareholders' Equity, we can calculate that Sarah's Bakery has $180 in Equity.
    • $200 = $20 + Shareholders' Equity
    • Shareholders' Equity = $200 (Assets) - $20 (Liabilities)
  • Using the D/E ratio formula listed above, the calculation would look like this:
    • D/E = $20 (Liabilities) / $180 (Equity)
    • D/E = 0.11111

Calculation Analysis:

  • Using this D/E ratio as one of their many tools, the banks may determine that Jim's Lemonade Shop is too leveraged as the D/E ratio is 3.0, meaning that for every $1 of Equity, there is $3 of Debt. 
  • On the other hand, the banks may determine that Sarah's Bakery does not have a lot of leverage as the D/E ratio is 0.11111, meaning that for every $9 of Equity, there is $1 of Debt.
  • If a bank wanted to lower their risk, they would typically give the loans to customers they believe could pay back the loan. In this case, a high D/E ratio means the borrower is high risk and a low D/E ratio means the borrower is low risk.

Debt to Equity Ratio Analysis

The actual calculation is open to interpretation as preferred shares can count as either debt or equity, and therefore someone working on a valuation can manipulate the figures to meet the appropriate multiple requirements. It is common for only long-term debt requiring interest payments to be considered, as short-term debt is quite common in most companies and usually does not affect the value or long-term prospects.

Higher ratios of D/E can indicate that the company is financing much of its activities through borrowing, and is highly sensitive to the money markets and interest rates. However, this can benefit shareholders if the increase in earnings is greater than the interest payments on the debt (i.e. if the debt is sustainable). Debt to equity is frequently included in loan agreements as a covenant saying that the firm must remain above a certain D/E ratio, or else it must pay back the loan.

Considerations for a Debt to Equity Ratio

Debt to equity values can only be compared within industries, as an 'acceptable' level of debt relative to equity is likely to vary across industries. For example, in the banking and finance industry, it is commonplace for these companies to have a high D/E ratio. On the other hand, small and private businesses both tend to have low D/E ratios as their owners.

It's important to ensure that there is a healthy balance in a company's debt and equity. Properly managed debt can be a great tool to help expand any business, it can increase the purchasing power of a company way past its typical capital limits. However, when improperly managed, it can quickly overwhelm a business and prevent them from properly servicing its debt. Improperly managed debt means it will be harder for businesses to get more loans and as a result, the cost of equity will increase.

 

 

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