Significance of Debt to Equity Ratio

What is debt to equity ratio?

Before I start discussing about the meaning and significance of debt to equity ratio, the best place to start is to define financial ratio. The reason is that, without having a basic knowledge of financial ratios, you may find it difficult to understand what the debt to equity ratio is all about.

What is financial ratio?

Financial ratios are the tools used in establishing relationship between a company’s financial information for the purpose of comparison. Financial ratios can be used to compare a company’s past performance or with the performance of other companies within the same industry. Essentially, ratios are calculated by dividing one number in the financial statements with another. Financial ratios can be classified into four categories namely, profitability ratios, liquidity ratios, leverage ratios and efficiency or operating ratios. Within each category of the ratios, there are other sub ratios. For example, under profitability ratios, there are gross profitability ratio, net profitability ratio, return on assets, return on investment, earning per share, investment turnover, sales per employee. Profitability ratios are mainly to provide information about the performance of the management of a company in using its resource to generate income. For liquidity ratios, the main focus here is the ability of a company to meet its current obligations. Under liquidity ratios, we have current ratio, acid test ratio, turnover ratio (i.e. Sales to receivable), days’ receivable ratio, cost of sales to payable, cash turnover or working capital. Under efficiency ratios, there are other ratios such as annual inventory turnover, inventory holding period, inventory to assets ratio, accounts receivable turnover and collection period. Leverage ratios cover debt to equity ratio, debt ratio, fixed asset to shareholders fund ratio and interest coverage ratio. Our main focus in this article is leverage ratio which measures the extent an individual or company relies on borrowing to finance its activities or obligations. Precisely, we shall restrict ourselves to debt to equity ratio.

Debt to Equity Ratio

Debt to Equity Ratio (DTE) is a financial leverage ratio used to measure the extent a company depends on debts to financial its operations in relation to the value of its equity. Debt to equity ratio is calculated by dividing the total liabilities of a company by its total equity. For you to actually understand this important ratio, you must be familiar with balance sheet or statement of financial position. The reason is that, the two elements of the formula of debt to equity ratio are derived from the balance sheet. On this note, I will like to shed some lights on what liabilities and equity stand for.

Liabilities mean the obligations of a company to others which arise during the course of its business operations. Liabilities are further classified into long term and short term liabilities or current liabilities. Long term liabilities are obligations which are not due for payment within a year. A good example is bank loan and lease. Current Liabilities on the other hand are obligations that are due and payable within one year e.g. trade creditors, bank overdraft and wages payable.

Equity or Shareholders’ Fund is the portion of a company’s assets that the shareholders own, as opposed to what they’ve borrowed. It represents all the money belonging to the company’s shareholders and this includes the share capital contributed and all profits retained in the company.

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Before lenders grant a loan to any company, they will like to look at its debt to equity ratio. Lenders are interested in this ratio because it allows them to measure whether a company will be able to pay its loans based on the amount of debts it currently owes. Also, lenders want to be sure that the value of the equity of the company will be able to cover its debts in case of liquidation. The lower the debt to equity ratio of a company, the more the likelihood that lenders will be willing to grant it loans. But if the debt to equity ratio is quite high, it may signal that the company is already carrying too much debt that may make it unable to pay its obligations to its creditors or lenders.

You should understand that one of the important decisions the management of a company will make is financing decision. When it comes to how the operations of a company will be financed, the management has the option of either to borrow or raise more capital from the shareholders. Each decision has its implications on the debt to equity ratio of a company. When a company increases its debt profile, its debt to equity ratio tends to increase. But if a company choose to raise more capital through its shareholders, this will increase the value of its equity thereby lowering its debt to equity ratio. The higher the debt to equity ratio, the higher the interest rate the lenders may require on their loans. The increase in the interest rate is a reflection of the risk that a company may find it difficult to meets its debt obligations.  There may be nothing wrong with a high debt to equity ratio if the management is able to use the debts to generate more income to its shareholders. That is, if the management can earn more income than what it pays out as interest on the loans. Anything that will enhance the shareholders’ worth will be welcome by them. Another thing about debt to equity ratio is that, it has direct relationship with the return on equity ratio. That is, the more of the company’s operations is financed by debts, the higher its debt to equity ratio and its return on equity.

Formula of debt to equity ratio:

Debt to equity ratio =     Total Liabilities/Total Equity

Example of how debt to equity ratio is calculated

Illustration 1

Company XYZ has a bank loan of $80,000 and a bank overdraft of $20,000 while its shareholders equity stands at $200,000. Calculate its debt to equity ratio.

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Solution

If you go back to the definition of liabilities above, I mentioned that liabilities are divided into current liabilities and long term liabilities. In the case, the company’s total liabilities will be $100,000 (i.e. $80,000 bank loan plus $20,000 bank overdraft). Overdraft is a current liability while the bank loan represents long term liability. The total equity is $200,000. Therefore debt to equity ratio can then be calculated as follows:

Debt to equity ratio        =             $100,000/$200,000

Debt to equity ratio        =             50%

Illustration 2

Let’s assume that Company XYZ needs additional $90,000 to finance its operations. It has three options. (i) To borrow the whole $90,000 (ii) To raise the entire amount through shareholders; and (iii) To raise the money through debt and equity financing equally. Let’s look at the effects of these three decisions on the company’s debt to equity ratio.

Option 1

Total liabilities = $190,000 (i.e. $80,000 bank loan + $20,000 bank overdraft + $90,000 additional debt).

Equity remains at $200,000

Debt to equity ratio will be $190,000/$200,000    =             95%

Option 2

Total liabilities = $100,000 (i.e. $80,000 bank loan + $20,000 bank overdraft).

Equity value is now $290,000 (i.e. $200,000 + $90,000 additional capital)

Debt to equity ratio will be $100,000/$290,000    =             34.48%

Option 3

Total liabilities = $145,000 (i.e. $80,000 bank loan + $20,000 bank overdraft + $45,000 additional debt).

Equity value is now $245,000 (i.e. $200,000 + $45,000 additional capital)

Debt to equity ratio will be $145,000/$245,000    =             59.18%

All these options are very simple. But one thing is clear, each of these financing decisions alter the existing debt to equity ratio of the company.

Example 3

But let’s assume that the company doesn’t want to alter its current debt to equity ratio of 50% and still wants to raise $90,000. How would the management achieve this?

This will require a little more complex calculation. A debt to equity ratio of 50% implies that the ratio of the debts of the company to the value of its equity is 1:2. To maintain this ratio, we need to add up the existing total debts and the existing value of the equity with the new capital that the company intends to raise.

New total amount = $390,000(i.e. $80,000 bank loan + $20,000 bank overdraft + $200,000 equity + $90,000 additional fund).

To maintain the same existing debt to equity ratio of 1:2, we need to divide the entire new amount by 3 ($390,000/3) = $130,000

Total liabilities will now be $130,000 (i.e.$130,000 x 1) while total value of equity will be $260,000 (i.e.$130,000 x 2).

So, to know how exactly the required $90,000 will be raised, we need to deduct the new total liabilities from the existing total liabilities and do the same for the value of equity. This can then be calculated as follows:

Amount to be raised through loan           = New total liabilities – Existing total liabilities

                                                                = $130,000 – $100,000 = $30,000

Amount to be raised through equity       = New total equity – Existing total equity

                                                               = $260,000 – $200,000 = $60,000

So, in order to maintain the existing debt to equity ratio of 50%, we need to raise the $30,000 through debt while the balance 0f $60,000 through the shareholders’ equity.

Let’s test the accuracy of our calculation by computing the new debt to equity ratio as follows:

New debt to equity ratio              =             New total debts/New total equity

New debt to equity ratio              =             $130,000/$260,000; which is 50%

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Effects of debt to equity ratio on return on equity

Financial ratios are interrelated. If you want to get the best out of financial ratios, you should learn how to relate the ratios with one another and be able to interpret them. For instance, lenders may not be keen to extend loans to a company with a high debt to equity ratio. But to shareholders, they will see high debt to equity ratio as a good leverage in as much that it helps the company generates more income. But I want you to understand that new capital, whether through debt or equity financing, will not start generating income immediately. Injection of new capital usually causes diffusion in the earnings of a company. So, let’s see how the injection of new capital of $90,000 into the XYZ Company in the example above will affect its return on equity.

What is return on equity? Return on equity (ROE) is a profitability ratio that provides insights on how a company has been able to generate income from its shareholders’ investment. Income in this context represents the amount distributable to the shareholders. That is, income after interest, taxes and preference shareholders’ dividends must have been deducted. High return on equity indicates that the company is using shareholders resources effectively and this usually attracts investors.  Return on equity is calculated as follows:

Return on equity              =             Net Income/Shareholders’ Equity

Example

In the example of XYZ Company given above, let’s assume that its net income is $40,000 while the shareholders’ equity stands at $200,000.

Return on equity will be $40,000/$200,000. This is 20%

So, let’s look at the effect that each of the financing decisions above will have on the company’s return on equity

Option 1

At 100% debt financing, shareholders’ equity remains at $200,000. Therefore the return on equity will remain at 20%

Option 2

At 100% equity financing, shareholders’ equity changes to $290,000. Therefore the return on equity will now be $40,000/$290,000 = 13.79%

Option 3

At 50% debt financing and 50% equity financing, shareholders’ equity changes to $245,000. The return on equity will now be $40,000/$245,000 = 16.32%

Option 4

If the existing debt to equity ratio of 50% is maintained, it will results into $60,000 equity financing and 30,000 debt financing, This will make shareholders’ equity to increase to $260,000. The return on equity will now be $40,000/$260,000 = 15.38%

Let’s summarise the computation in the table below:

No Equity’s Value ($) Total Debts ($) DTE Ratio ROE Ratio
1 200,000 100,000 50.00% 20.00%
2 200,000 190,000 95.00% 20.00%
3 290,000 100,000 34.48% 13.79%
4 245,000 145,000 59.18% 16.32%
5 260,000 130,000 50.00% 15.38%

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From the above table, we can see clearly that any time there is an injection of new equity fund, the return on equity reduces. The higher the amount of fresh equity fund introduced into a company, the lower its return on equity becomes. That is why investors will usually prefer debt financing to equity financing as long as the management is able to utilize the debt to earn more income for the shareholders. By extension, the stocks of a listed company with high return on equity will likely enjoy price increase as investors will like to buy such stocks. The more the demands for a stock, the higher the stock price may grow. On the contrary, lenders may see a company with a debt to equity ratio of 95% too risky to be granted new loans. Also, such company may be spending too much money on interest expenses. In a situation whereby the company is not able to pay its interest, it may be faced with liquidation. Therefore, the management should know how to balance how they source for funds. If a company is already having a very high debt to equity ratio, the management can do two things to lower it. It is either the company pays down its debts or inject new equity funds.

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