The debt to equity ratio of a business is a measure of the contribution of the creditors and shareholders or owners towards the capital invested in a business. It is a financial tool that is used to get an idea of how much of the borrowed capital can be repaid in the event of liquidation using the shareholder’s contribution.
The debt to equity ratio can be simply defined as the capital structure ratio that is used to evaluate the financial stability of business in the long-term using balance sheet data. While assessing the company’s position, the debt-to-equity ratio is viewed differently by different sections of people like lenders, investors, management and the government. The interpretation of the financial ratio varies with the objective with which it is looked.
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For example, investors and creditors use this data to make effective investment decisions. If the business has enough capital to fulfill its short-term and long-term obligations then the business is considered to be solvent. Thus this data is used to understand the long-term solvency of a company or business by creditors and investors.
The debt-to-equity ratio is a simple equation that provides data regarding the collection of funds and how the fund has been raised to run the business. It is considered to be an important indicator of the financial health of a business. It is mainly used to understand the stability of the company and its ability to raise additional capital to fund expansion and growth.
If you own a business, this ratio will be used when you are about to avail a loan or business line of credit. Investors also view a company’s debt-to-equity ratio as an important financial metric as it helps them understand the risks involved in investing in a particular company. Higher the debt-to-equity ratio of a company, the riskier investment it is.
The debt-to-equity ratio is considered good when it stands around 1 to 1.5. But the ratio is not constant for every industry and varies depending on the industry because some industries use more debt than financing those other industries. Certain industries like the financial and manufacturing, which are capital intensive often, display a higher debt to equity ratio which can be greater than 2.
When the company has a high debt to equity ratio then it indicates that the business uses debt as the main way to finance the business growth. Also, companies that make significant investments in assets and operations have a higher debt to equity ratio.
See Also: Types Of Debt Instruments
This is often perceived differently by investors and lenders. For a lender, a higher debt-to-equity ratio means the business is under considerable debt and may not be able to repay its debts. If the debt to equity ratio of the business is lower it means the business has enough funds and it doesn’t rely much on borrowing to fund its operations.
On the contrary, investors are likely to invest in ventures that have a higher debt-to-equity ratio. Investors often refrain from investing in ventures with low debt to equity ratio as the business hasn’t yet realized its full potential or value through public borrowings.
Now that we are already aware of what debt to equity ratio is, let’s try to understand its formula:
The two elements that are included in the formula are:
Total liabilities: this represents the total debt owed by the company that includes short-term and long-term debt and other liabilities like bond sinking funds and deferred tax liabilities.
Shareholder’s equity: the shareholder’s equity is the result of total liabilities minus the total assets which are found in a company’s balance sheet.
A higher debt to equity ratio can sometimes be good as it indicates that a business can easily service its debt obligations through its cash flows and is using the leverage to increase the equity returns.
In cases when the company’s debt-to-equity ratio is too high, the losses are compounded down and the company may not be able to repay its debts. In such cases, the cost of borrowing becomes very high as the company’s WAAC and cost of equity becomes high, thus bringing down the price of its shares.
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