What is the Debt to Equity Ratio?
Leverage ratios like debt to equity are also useful to determine what portion of required capital is funded through debt. Debt to equity is the ratio between total liabilities and total equity on the balance sheet.
Debt to equity ratio = (total liabilities / total equity)
The debt to equity ratio can be used as a tool to quickly assess the debt load of a company with respect to its shareholder equity. A company that has $2,000,000 in total liabilities with $500,000 of total equity will have a debt to equity ratio of 4. It can be simply stated as: For every dollar financed with equity, the company financed $4 with debt.
Balance sheets with a debt to equity ratio of more than 1 are considered to be overleveraged. When the value of the ratio is less than 1, it is generally considered to be healthy. But such arbitrary numbers need not be considered to be rules. It will vary widely depending on the industry in which the company operates.
Companies that operate in asset-heavy industries like construction, infrastructure, airline, and hospitality will have a high debt to equity ratio — generally much greater than 1. On the other hand, asset-light companies like tech companies have low debt to equity ratios. It is wise to compare the debt to equity ratios of companies operating within the same industry. The ratio can be used as a comparative tool to assess a company’s financial strength.
Implications of debt to equity ratio
The debt to equity ratio gives an estimate of the debt on the balance sheet in a single glance. Here are some of the implications of debt to equity ratios:
- Debt has regular interest payments, which reduce the profitability of the company. With all other things equal, a company with a lower debt to equity ratio will be more profitable than companies with high debt to equity ratios.
- In the event of company dilution, shareholders can redeem any value only after all debt is paid.
- Debt can be used to effectively manage taxes as the interest accrued may be tax-deductible. The reasons behind the debt load of the company need to be investigated before arriving at conclusions.
- Interest payments for debt reduce the effective working capital available to the firm. Companies will have to adjust to working with lower working capital or make other provisions to maintain adequate working capital.
- Higher debt makes the company inherently risky. Banks will be hesitant to give more loans. A high debt to equity ratio can be detrimental to investors too.
- When a company has a high debt to equity ratio, it can attract new loans at a higher interest rate. On the flipside, companies with a lower debt to equity ratio can avail loans at lower interest rates.
The debt to equity ratio can be used as a cursory tool to assess the debt component on the balance sheet. There’s no single rule regarding the value of the debt to equity ratio that applies to every company. To arrive at a sensible conclusion, a company’s debt to equity ratio should be compared with the same financial ratio of companies in the same industry.