The debt to equity ratio is the ratio between a company’s financial debt to its shareholder’s equity. The higher the debt to equity ratio, the more financial loan (bank loans) the company possesses over financial investors.
In simple words, it is the ratio of the company’s total debt (short term and long term) to its equity shareholders. The debt to equity ratio helps in analysing the company’s financial debt vs its own funds. It shows the ability of shareholders equity to cover all outstanding debts in the case when the business is going down. We can find the debt to equity ratio in the company’s balance sheet and can analyse the company’s financial health.
How to calculate debt to equity ratio
By using the debt to equity ratio formula, we can easily calculate debt to equity ratio of any company.
Debt to equity ratio = Total debt / Total shareholders equity
Total debt is the sum of short term debts and long term debts.
Short term debts are referred to debts that are expected to be paid within one year. The short term debts are also known as current liabilities.
Debts that are payable in more than one year are referred to as long term debts.
What is equity?
The initial capital raised by the company’s owner or by investors is called equity. This capital is used in fund purchasing, investing in projects and fund operations.
To calculate the equity of a company, we use the formula:
Shareholder’s equity = Total Asset – Liabilities
Therefore, equity is the amount that would be returned to the shareholder when all the assets are liquidated and the company’s debts are paid off.
Equity Investment Example
Let us understand it by an equity loan example.
Suppose you are about to start your business and you need a certain sum to establish your business. For instance, let’s take this sum of money to be $100000. This money can be raised by you (owner), investor and through bank loans.
When this fund is raised by the owner and investor, this sum of money is known as stockholders equity. Whereas, the amount of money borrowed from the bank is the debt.
In this example, let us consider you invested $30000 and the rest of $70000 is through a bank loan. So you became 30% owner of the company.
By this statement, we can conclude that owner’s equity is the amount of capital invested and owned by the owner of the company. Here, in this example, you became 30% owner of the company. As you pay-off, your loan to the bank, your ownership in the company will increase. Also by buying equity, you get voting right in the company and that depends upon the per cent of your equity.
By this statement, we can also conclude that, when you buy shares of a company you also become the owner of the amount you invested in that company. The company’s performance will determine your profit or loss.
You can check the equity of a company in its balance sheet. Under the equity and liability section, you can find the equity of that company. By analysing the brand equity you get an idea of the company’s health.
Good Debt To Equity Ratio
Are you wondering, is debt consolidation good or bad for a company? Let’s see one more example to see if little debt is good or bad for a company. And if yes, then what is a good debt to equity ratio.
In this example, a person starts his business with a capital investment of $1M. Let’s see the difference between the RoE of a company in two cases.
|Capital Requirement $1M||Case 1||Case 2|
|Debt @ 14% interest||500K||XXX|
|Profit after interest (Tax not included)||130K||200K|
In case one, the person raises funds of $500K by own and through investors and loans the remaining $500K from the bank at a 14% interest rate.
Let’s assume, by the end of the year the company made a profit of $200K.
Therefore, the interest amount he has to pay by the end of the year comes to be
14% of $500K = $70K
Then, his profit after paying his interest would be
$200K – $70K = $130K.
If we calculate the RoE in case 1,
RoE = 130Kx100/500K = 26%
Hence the RoE = 26%
In the second case, let’s see what happens when the person raises funds of $1M by own and through investors only. Remember, he did not loan any money from the bank.
Let’s consider, he made the same profit by the end = $200K
As he did not loan any money, he doesn’t have to pay any interest.
Therefore, his profit by the year = $200K
Seems good right? Lets calculate his RoE
RoE = 200Kx100/1M = 20%
Hence, his RoE = 20%
By this example, we have seen a little debt is good as it increases the Return on Equity.
In the previous example, we have seen a little debt has a positive effect on RoE. Now let us take one more example so that we may conclude what is a good debt to equity ratio.
In this example, let’s take the same scenario. A person requires $1M to start his company. In case 1 we will see what happens when he loans half of his money. Case 2 is the study when he raises funds through equity.
|Capital Requirement $1M||Case 1||Case 2|
|Debt @ 14% interest||500K||XXX|
|Profit after interest (Tax not included)||-20K||50K|
Let us see what happens when he invested $500K through equity and the remaining $500K he took a loan from a bank at 14% interest.
Total equity = $500K
Total Debt = $500K
Let’s assume he made a profit of $50K by the end of the year.
Calculating his interest on $500K at 14%
Intrest = 14% of $500K = $70K
So the profit is $50K and the interest he has to pay to the bank is $70K. Therefore he ends up losing $20K from his pocket for paying his interest.
His RoE comes to be -20Kx100/500K = -4%
By this example, we have seen that his debt is making a $20K hole in his pocket. His RoE comes to be -4%
In the second case, he has invested $1M on his own and did not have any bank loans.
Let us assume that he made the same profit of $50K, as in the previous case.
As he did not have any loan, therefore, he doesn’t need to pay any interest.
Consider tax to be negligible, his total profit becomes $50K
Now let’s calculate his RoE
RoE = 50Kx100/1M = 5%
Therefore, RoE = 5%
In this example, we have seen how debt can adversely affect a company’s performance.
What is a good debt to equity ratio
By the previous two examples, we can conclude that the Return On Equity of a company depends upon the profit the company makes. In example one, when the company was making a good profit, then a little debt was good for the company’s RoE, whereas in example two, we have seen when profit was low, debt gave a negative RoE. It will degrade the company’s value. Therefore, if a company is making a good profit then, a little debt is good for the company.
It is considered that 2:1 is a good debt equity ratio for companies as it can lower a firm’s weighted average cost of capital (WACC).
However, a few people consider that the company should not possess any debt.
Let me ask you a question. In which company would you invest your money during the lockdown phase when businesses are going down? A company that has a lot of debt or a debt-free company?
Well, the answer is clear. Pandemic has hit businesses and most companies have to face losses. If you invest in a company where there is debt, chances are that the company may go bankrupt, as they have to pay for the debt. While companies that are debt free will make less profit or no profit but has much strength to manage their finances during hard times.
Debt to equity ratio by industry
Let’s understand it by an example, why debt to equity ratio by industry varies.
We know that,
RoE= Total liabilities x 100 / Total Equity
RoE = $200000 x 100/ $100000
Therefore, RoE = 200%
When RoE is greater than 100% then, it means the company is heavily financed through debt. This is not always a bad thing.
By this example, we can quantify that,
For every $1 finance through equity, the company has $2 finance through debt. Again, the question arises that whether the 200% debt to equity ratio is good or bad? Unfortunately, there is no standard debt to equity ratio that works for every company. It is because different companies have different business models and operate in different industries.
Therefore, the debt to equity ratio depends upon industry to industry. Industries like real estate are heavily financed because they require heavy machinery and have to run the cycle for about three to four years to complete one project. Similarly, banking sectors and power companies also have high debt to equity ratios. Whereas companies operating in retail, software services have lower debt to equity ratios.
Therefore, we should compare the debt to equity ratio of companies that operate in the same industry.
Yes, the debt to equity ratio can be negative. In the previous example, we have seen a negative D/E ratio. A negative D/E ratio indicates the company has more liabilities than assets. Generally, investing in these companies might be risky because they may go bankrupt.