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The most important thing to examine while gauging the health of a particular company is its financial standing. The debt-to-equity ratio or risk-gearing ratio analyses a company's financial leverage. The ratio also calculates the weight of total debt and financial liabilities against total shareholder’s equity. This article focuses on the debt-to-equity ratio meaning.
What is the Debt-to-Equity ratio?
The debt-to-equity ratio definition states that it is used to gauge the company’s capability to pay back its obligations. It shows the overall health of a particular company. If the debt-to-equity ratio is high, the company receives more financing by lending money. Hence, it may be entering risky territory. Further, if debts continue remaining at elevated levels, the company may go bankrupt.
Several investors and lenders opt for a low debt-to-equity ratio as it safeguards their interests. However, comparing the debt-to-equity ratio across different industry groups is tough, as ideal debt amounts vary according to their requirements.
For instance, high-CAPEX industries like aviation, natural resources, and automobiles require heavy investments. Promoters may not have enough accruals to cover the required capital expenditure. Hence, external borrowings would be vital, which might raise the debt-to-equity ratio.
How is the Debt-to-Equity ratio calculated?
The debt ratio formula is calculated by dividing a company’s total liabilities by its shareholder’s equity. Mathematically it can be represented:
Debt-to-equity ratio = Total Liabilities/Shareholder’s Equity
The total liabilities include short-term debts, long-term debts, and other committed liabilities.
For instance, there is a firm with total equity and liabilities of INR 2,50,00 and INR 1,00,000, respectively. Hence, the firm has a gearing ratio of 0.40
Debt to Equity ratio interpretation
The debt-to-equity ratio also helps one analyze a company’s financial strategy. One can gauge whether the company uses debt or equity financing for running its operations. There are two different types of debt-to-equity ratios.
● High debt-to-equity ratio: A high debt-to-equity indicates high risk. For example, if the company is borrowing money from the market to finance its operations for growth, it means a high debt-to-equity ratio.
● Low debt-to-equity ratio: A low debt-to-equity ratio means the equity of the company’s shareholders is bigger, and it does not require any money to finance its business and operations for growth. Simply put, a company with more owned capital than borrowed capital generally has a low debt-to-equity ratio.
Benefits and drawbacks of high debt-to-equity ratio
An elevated level of gearing ratio offer several benefits.
● Strong company: A high debt-to-equity ratio signifies that a firm can fulfil debt obligations through its cash flow and leverage may be used to increase equity returns and strategic growth.
● Cheaper financing: The cost of debt is lower than the cost of equity. Therefore, increasing the debt-to-equity ratio up to a specific point can decrease a firm’s Weighted Average Cost of Capital (WACC).
However, it also has the following drawbacks.
● Solvency threats: If the company has a high debt-to-equity ratio, any losses incurred will be compounded. Hence, the company may find it difficult to repay its debt obligations.
● Escalating borrowing costs: If there is a sudden spike in interest rates, the borrowing costs will shoot up. This might also push up the company's WACC. As a result, this may adversely impact a company's profitability and stock price.
What is a good debt-to-equity ratio?
Although it varies from industry to industry, a debt-to-equity ratio of around 2 or 2.5 is generally considered good. This ratio tells us that for every rupee invested in the company, about 66 paise comes from debt, while the remaining 33 paise comes from the company’s equity.
What is a bad debt-to-equity ratio?
When the ratio is more than 4, it indicates an extremely high level of leverage. This is likely to draw serious attention from firms' lenders. A high gearing ratio does not necessarily mean the company has a problem. One has to identify why the debt load is so high.
For instance, if a company has just invested in a mega project, it is perfectly normal for its ratio to rise. Eventually, the company will profit from its investment and its ratio will tend to fall to more normal.
Furthermore, it is important to note that some industries naturally require a higher debt-to-equity ratio than others. For example, a transport company has to borrow a lot to buy its fleet of trucks, while a service company will practically only have to purchase computers.
What is the long-term debt-to-equity ratio?
It involves the same calculation, except that it only includes long-term debt. Thus, you subtract
the balance on the operating line of credit and the amounts owed to suppliers from the liabilities. By keeping only the long-term debt, it is more revealing of the company’s true debt level.
While for some businesses, eliminating short-term debt does not make a huge difference to the result, for others, it does. Some types of businesses, such as distributors, need a lot of inventory, which adds to their debt. However, those amounts are paid off as the company makes its sales.
Is the debt-to-equity ratio widely used by banks?
he debt-to-equity ratio is interesting as one can track it monthly. However, its use is decreasing. Fundamentally it is a balance sheet-only ratio. It does not look at the funds generated by the company, that is, the cash flow.
For example, a company that has INR 1 crore in after-tax profits and another that benefited from its good years in the past and now has a net loss of INR 1 crore annually can have the same debt ratio. However, the former would be in a much better position to repay its debt than the latter.
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Frequently Asked Questions
Mostly, yes, as the company does not appear highly leveraged.
Yes, but companies may need external borrowing to finance rapid growth. Tendencies of risk aversion may limit a company’s growth potential.