It is imperative and a task of paramount importance for an investor to examine the financial performance of a company from every angle before investing a single penny in that company. The true worth of the company can be detected by analyzing its financial ratios.
One such crucial financial ratio is the Debt to Equity ratio. The other names for this financial ratio are Debt-Equity ratio, Risk Ratio or Gearing.
What is the Debt-Equity Ratio?
Debt to Equity ratio is a leverage ratio that indicates how much debt is involved in the business vis-à-vis the equity in the business. It tells us how much the business is leveraged. It brings to light the fact of how much the company is dependent on the borrowed funds and how much can it meet its financial obligations on its own.
Debt to Equity Ratio = Total Debt / Total Shareholders’ Equity
Here, total debts include short term debts, long term debts, and other fixed payment obligations.
How to Judge whether a Debt-Equity Ratio is Good Enough?
Since the word debt is synonymous with the word burden, it helps us to understand that the lower the debt-equity ratio, the better it is, for the company as well as its investors.
But there are many conditions that lead to a good debt to equity ratio in a particular market situation, so one should not judge a company quickly based on its debt to equity ratio but study it in harmony with other conditions.
If the company has significantly higher returns than the interest costs it has to pay, then higher debts actually enhance the value. However, if the returns are at par or even lower than the interest costs that are to be paid; higher debts may lead to a loss for the shareholders. Also, a lower debt-equity ratio indicates that there is a lot of scope for expansion of the company since the company has a lot of fund-raising options as well.
The optimal level of Debt to Equity ratio varies depending upon the industry that the company belongs to and what are the prevalent market conditions. If the company has a Debt to Equity ratio lower than 1, then the company has a higher scope of expansion.
A good Debt to Equity ratio will range from 1 to 1.5, depending on the industry, since this means that the debt required for the company’s capital is not (much) higher than the equity. This indicates that the company is able to meet its financial obligations in a sufficient manner. Some large public companies’ debt-equity ratio may vary from 1.5 to even higher than 2.However, a good Debt to Equity ratio does not generally exceed the mark of 2.0 for most companies, which actually indicates that two-third of the company capital comes from borrowed funds.
What is the Implication of a High Debt-Equity Ratio for the Investors?
- Protection of Interest Costs: As the ratio keeps increasing, it indicates that more and more capital of the company has been financed by debts in lieu of financial sources of its own. This increasing trend of the ratio can be dangerous for a company, to say the least. Investors and even creditors should prefer those companies which have a lower debt-equity ratio since their interests will naturally be better protected in the case of the business starting to decline.
- Volatility & Increased Interest Costs: Higher debt-equity ratio indicates that the company has been totally focusing on financing its growth, in an aggressive manner, through borrowing. The additional interest expense can result in volatile earnings, which might prove to be a problem for investors.
- May lead to Bankruptcy: It is true that if a company borrows more and more finance and it can use this finance to facilitate its increasing operations, the generation of earnings and revenue will be potentially higher if these operations were financed without the outside help.If the revenue generated is enough to be in excess of the interest costs, then the shareholders will benefit because of the increased share of every shareholder from the earnings. However, the trade-off point is the cost of financing this debt which may or may not outweigh the return that the company generates. If this cost exceeds the capacity of the company to pay off the debts and maintains proper operations in the company, then it could lead to bankruptcy. This bankruptcy will leave the shareholders without a single penny.
- May lead to Violation of Debt Covenants: If the specified debt to equity ratio of a company is exceeded under a debt covenant (stipulations as to what to do or not to do in relation to certain things in the business), the existing lender might call upon the entire debt which may lead to a financial problem or even crisis in the company.
So to conclude, it is always considered wise to invest in a company with a moderate debt to equity ratio since it means steady returns and low risk of loss.
-By Mahek Bajaj