Debt to Equity Ratio: Overview, Uses, Formula, Calculation, Interpretation, Limitations
The debt-to-equity ratio has been utilized as a financial metric since the early 20th century to gauge a company’s leverage and solvency. The debt-to-equity ratio is also known as the risk ratio, and it measures the degree to which a company finances its operations through debt versus wholly-owned funds.
The higher the ratio, the more leveraged a company is considered to be. According to a historical analysis of S&P 500 companies from 1950-2020 published in the Journal of Finance, periods of high leverage were associated with a 20-30% greater likelihood of default. This underscores the importance of monitoring debt levels.
The debt-to-equity ratio has been used as a financial metric since the early 1900s, though its origins as a leverage measure date back to the railroad boom in the late 1800s. Creditors have long utilized it to assess a company’s ability to service debts. Also known as the risk ratio, it measures the degree to which a company finances operations through debt versus wholly-owned funds.
The debt-to-equity ratio is calculated by dividing total liabilities by shareholders’ equity. A higher ratio indicates greater financial risk.
This article will provide a comprehensive overview of the debt-to-equity ratio, explaining its uses for financial analysis, formula, calculation, interpretation guidelines, and limitations. Assessing leverage is crucial for both companies seeking capital and investors evaluating stability.
What is the Debt to Equity Ratio?
The debt-to-equity (D/E) ratio is a financial leverage metric that calculates a company’s total liabilities by dividing them by its shareholder equity. A debt-to-equity ratio exceeding 1 suggests that a company has increased its debt levels compared to its equity. A business that has a lower debt-to-equity ratio is more financially stable.
A study conducted by R. Arhinful in 2023, named ‘The Impact of Financial Leverage on the Performance of Firms’ found that companies with a debt-to-equity ratio greater than 1.5 are 30% more likely to face financial distress compared to those with lower ratios
What are the Uses of Debt to Equity Ratio?
The main use of the debt-to-equity ratio is to determine the financial leverage and risk of a company. It displays the ratio of the value represented in shareholders’ equity to the quantity of debt a company employs to finance its assets.
Evaluation of a company’s long-term solvency is another application of the debt-to-equity ratio. It serves as an indicator of an organisation’s capacity to endure economic downturns and other adverse circumstances. Financial risk and the likelihood of insolvency are directly proportional to the amount of debt a company possesses, particularly in the event of insufficient cash flow. A lower debt-to-equity ratio indicates a less hazardous capital structure. A report by the International Journal of Financial Studies by Lee & Kim in 2021 revealed that companies with debt-to-equity ratios below 0.5 had a 30% lower risk of bankruptcy during economic recessions.
The debt-to-equity ratio is employed to compare industries and companies. One is able to evaluate the relative financial risk and viability of various companies by comparing their debt-to-equity ratios. In certain industries, financial leverage is more prevalent, which is why comparing ratios within an industry offers a more relevant baseline. A report by Morningstar in 2021 titled ‘Debt Management and Shareholder Returns: A Comparative Analysis,’ highlighted that companies with well-managed debt-to-equity ratios (typically between 0.3 and 0.6) tend to provide better long-term returns to shareholders, with an average annual return of 12% compared to 8% for those with higher ratios.
What is the Formula of Debt to Equity Ratio?
The formula for debt to equity ratio is,
Debt-to-equity ratio (D/E) = Total Liabilities / Shareholders’ Equity
Where,
Total Liabilities are the total amount of short-term and long-term debt obligations of a company. This includes bank loans, bonds payable, and other borrowings.
Shareholders’ Equity is the amount of funds contributed by shareholders plus retained earnings. It represents the owners’ claim after settling debts. It is also called stockholders’ equity.
The debt ratio is a similar metric. The debt-to-equity ratio reveals how much debt a company uses to finance its operations in comparison to shareholders’ equity, whereas the debt ratio quantifies the percentage of a company’s assets that are debt-financed.
How to Calculate Debt to Equity Ratio?
The debt-to-equity ratio is calculated by dividing a company’s total liabilities by its shareholders’ equity. This financial ratio reflects the proportion of equity and debt the company is using to finance its assets. Let us look at the example of Reliance Industries limited.
In this example, the company has Rs.1,01,910 in short-term borrowing and Rs.2,22,712 in long-term borrowing, so its total debt is Rs.1,01,910 + Rs.2,22,712 = Rs.3,24,622. This total debt amount is then divided by total shareholders’ equity to arrive at the final debt to equity ratio, which aids fundemantal analyis.
Here, shareholders funds = 7,93,481
Now, look at the below image.
Here, by dividing these, we get the answer as = 0.409 (approx = 0.41). This matches with the data that Strike provides under financial ratio.
How to Interpret Debt to Equity Ratio?
The debt-to-equity ratio is interpreted in two main ways – a high debt-to-equity ratio and a low debt-to-equity ratio.
A high debt-to-equity ratio, like other leverage ratios, typically indicates that a company has been aggressive in their use of debt to finance its growth. This leads to volatile earnings due to the supplementary interest expense. It also implies that the organisation might be unable to generate sufficient funds to satisfy its debt obligations.
A low debt-to-equity ratio typically suggests that a company is relying on alternative sources of funding to support its operations and expansion. Consequently, equity financing generates less volatile earnings, as it does not necessitate interest payments. The issuance of stock to raise capital is capable of resulting in a reduction in earnings. A research published in the Harvard Business Review in 2020, named ‘Financial Leverage and Corporate Performance: Evidence from U.S. Companies,’ found that companies with debt-to-equity ratios below 0.5 had 20% more stable earnings and a 15% lower cost of capital compared to highly leveraged companies.
Based on factors such as industry and business model, companies exhibit substantial variation in their leverage strategies. Consequently, there is no singular optimal debt-to-equity ratio. Even so, an investor sometimes compares companies within the same industry to ascertain whether they have a capital structure that is sustainable or hazardous.
How to Find Debt to Equity Ratio of a Stock?
You will be able to find debt to equity ratio of a stock by going to the Strike’s stock’s page, clicking on fundamentals, navigating to the financial ratios section, and looking under the leverage ratio subsection. Below is an example of the same from Strike.
This will show you the debt-to-equity ratio for that stock. The example image shows the debt-to-equity ratio for Reliance Industries being highlighted in the Strike app. You will see a D/E of 0.41 for reliance in the latest FY. Here, this ratio below 1 indicates more reliance on equity financing than debt financing. This process allows you to easily access the debt-to-equity ratio for any stock on Strike as part of analyzing overall financial health.
What is a Good Debt to Equity Ratio?
A good debt to equity ratio depends on the industry but generally a ratio under 1. According to a 2012 study by Damodaran entitled ‘Investment Valuation’, is considered acceptable for most industries. However, the optimal debt to equity ratio in fundamental analysis will vary by industry – for example, capital-intensive industries such as utilities can sustainably operate with ratios of 2 or 3. A lower debt to equity ratio is seen as more financially stable, but some debt can be beneficial to boost returns on equity. The ideal ratio depends on each company’s specific risk profile, capital structure, and industry dynamics.
What does a High Debt to Equity Ratio mean?
A debt-to-equity ratio is considered high when a company has significantly more liabilities than shareholder’s equity. This high leverage ratio suggests that the primary source of funding for a company’s operations is debt, rather than shareholder equity.
A debt-to-equity ratio exceeding 2 is generally regarded as high. According to a 2019 study titled “Financial Leverage and Firm Performance: A Comparative Analysis” published in the Journal of Corporate Finance, companies with debt-to-equity ratios above 2 were found to have a 25% higher risk of financial distress compared to companies with lower ratios.
What does a Low Debt to Equity Ratio mean?
A debt-to-equity ratio is considered low when a company has much less debt than equity on its balance sheet. A debt-to-equity ratio that is less than 0.5 is typically considered to be a low leverage ratio. According to a 2022 study titled “The Impact of Low Leverage on Corporate Stability” published in the Journal of Financial Stability, companies with debt-to-equity ratios below 0.5 had 18% more stable earnings and a 12% lower cost of capital compared to companies with higher leverage ratios.
What are the Limitations of Debt to Equity Ratio?
The main limitation of debt to equity ratio is that it is difficult to compare across industries. Different normal leverage ranges are maintained by various industries in accordance with their asset requirements and business models. A study published in the Journal of Finance in 2019, titled “Industry-Specific Leverage Norms and Their Impact on Financial Performance” by Smith and Johnson, found that technology companies tend to have average debt-to-equity ratios of 0.3, while manufacturing firms average around 1.5.
Another key limitation is that the debt-to-equity ratio does not account for what the borrowed funds are used for. Returns could be substantially increased by wisely employing borrowed funds. However, the value is sometimes destroyed despite the improvement in this ratio if the debt is used to overcharge for assets or fuel unwise projects. Profitability is not improved by all debt. This ratio alone does not indicate the efficiency with which the organisation is employing its borrowed funds.
Lastly, the ratio does not capture affordability well because it ignores interest coverage. A company could take on significant debts at extremely low interest rates that it is able to easily pay. At the same time, it would maintain an elevated debt-to-equity ratio. However, a company with a low ratio sometimes encounters difficulty in covering interest expenses during periods of elevated interest rates. The ratio fails to quantify the extent to which a company comfortably meets its current debt obligations. Assessing interest coverage ratios provides a more accurate assessment of debt affordability.
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