The debt to equity ratio is a metric that tracks how leveraged a company is by estimating how many dollars of debt it has for each dollar of equity. The Debt to Equity Ratio is employed as a measure of how risky is the current financial structure, as a company with a high degree of leverage will be more sensitive to a sales downturn.
What is the Debt to Equity Ratio?
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Determining the degree of leverage of a business is an important task of any lender and financial analyst, in order to understand how exposed a business is to a potentially negative performance in its sales. A highly leveraged business will often incur in large interest expenses and also, in large principal payments that may not be possible to refinance.
If the performance of the projects where the debt is invested in doesn’t turn out to be as good as it was expected, the business may find itself in a difficult position to pay for its commitments, and this is the risk that a high degree of leverage brings into the mix.
While debt is healthy to push growth in most instances, exceeding the boundaries and pushing the Debt to Equity ratio will eventually have a negative impact in the business. For this reason, tracking the evolution of the Debt to Equity ratio throughout time will provide a good picture of how a company is behaving in terms of its leverage.
Debt to Equity Ratio Formula
The debt to equity ratio formula is calculated below:
D/E = Total Liabilities / Total Shareholder’s Equity
Debt-to-Equity Ratio Equation Components
Total Liabilities: The sum of both short term and long term debt commitments as reported in the business’ Balance Sheet.
Total Shareholder’s Equity: The sum of all equity items related to capital invested by the business’ shareholders either directly or indirectly, as is the case of retained earnings.
A common variation to this formula will substitute Total Liabilities by Long-Term Liabilities only, as short-term debt is usually offset by current assets and it’s a part of the business working capital.
While the formula seems to be very straightforward, identifying which items to include as ‘Long Term Debt’ and which to include as ‘Shareholder’s Equity’ is not as straightforward as it seems. An analyst has to dig deeper into the notes attached to the company’s financial statements in order to fully understand which items can be categorized as such.
The ratio can be either expressed as a percentage or in plain numbers.
Debt to Equity Example
Nu Art LLC is an art gallery located in San Francisco that deals with paintings and sculptures. The business trades pieces of very high value and in order to get special prices from artists it purchases some of them, the most promising ones, by paying upfront, at a discounted price.
The company’s financial structure consists in a mix of a small amount of long term debt plus equity but the Board of Directors has decided to expand the company’s long term debt significantly to take advantage of the current low prices of certain key pieces.
The current financial structure of the business is the following:
Long Term Debt: $1,240,000
Shareholder’s Equity: $12,560,000
Current Debt to Equity Ratio: 9.9%
The Board of Director’s proposal involve taking an additional $3,450,000 loan from a financial institution, which will push the Debt to Equity Ratio higher. The new Debt to Equity Ratio can be calculated as follows:
D/E = ($1,240,000 + $3,450,000) / $12,560,000 = 37.4%
Even though the company will now have a higher degree of leverage, compared to other firms in the same industry, it is actually positive for the business to take advantage of this opportunity and employing debt seems to be the right way to do it.
Debt to Equity Ratio Analysis
Financial planners employ the Debt to Equity Ratio and the Debt to Asset Ratio to model for different potential financial structures. By comparing the net income of each scenario and the level of risk it will take to achieve it, the management team of the company can decide what would be a suitable degree of leverage for the business.
Additionally, investors and financial institutions also keep track of the evolution of the Debt to Equity ratio over time to understand the business riskiness. The higher the D/E ratio, the riskier the business becomes.
Different industries, though, have certain ‘normal’ levels of Debt to Equity. This depends on the dynamics of the industry. For example, a capital intensive business may need to leverage itself much more than perhaps a software business. In this sense, a healthy D/E ratio can be understood as one that is ‘normal’ for the industry in which the business is in.
Nevertheless, a ratio higher than 1 should call for a deeper analysis of the business current debt situation. A ratio of 1 (100%) means that the business finances half its assets with debt, which may be too high of a ratio for certain businesses. Also, the interest rate of the debt is also an element to take into account to determine if the D/E level is too high.
In the example above, while the gallery is taking a significant loan, the Debt to Equity ratio is still conservative.
Debt to Equity Ratio Uses, Cautions, Pitfalls
A special degree of attention should be put into what is considered as relevant debt for a business, in order to adequately calculate the D/E ratio. For example, non-interest bearing debt may not be considered as something to add on the debt portion of the D/E ratio by some analysts. On the other hand, short-term debt may not be added either, unless the company operates with a negative working capital.
Furthermore, equity items should also be picked carefully. Contingency items or certain kinds of ‘funds’ that are not actually 100% attributable to shareholders, may be excluded from the equity portion of the formula also.
In any case, the ratio may be calculated by adding and excluding these items. If the variation between each model is significant, it should call for further due diligence to determine if any of those items can actually be considered as relevant for the metric.