Debt to Equity Ratio: What Do Debts Mean?
There are plenty of instruments for analysing companies, financial ratios among them. Today I am speaking about one of them — the Debt to Equity Ratio, or Debt/Equity.
It demonstrates the ratio of the capital that the company owns to the one it loans. Simply speaking, it is the debt of the company divided by its equity, just as the name goes. The multiplier helps to understand what comprised the assets of the company. In certain cases, D/E is also called financial leverage.
The ratio is useful for checking the current financial situation of the company, whether it will be able to develop in the future, and whether it will generate profit.
The formula for D/E is as follows:
Debt to Equity Ratio = Liabilities / Assets
- Assets of a company are all the money it has.
- Liabilities are all the money is borrows (credits, loans, debts).
- Short-term liabilities are used for paying off cash gaps. They are to be paid off within a year which makes them "cost" more.
- Long-term liabilities are used for bringing to life large projects. They are to be paid off within several years which makes them "cost" less. In other words, accounting for inflation, the more time passes since the time when the money was borrowed till the moment it is to be returned, the less this debt costs.
Information about liabilities and assets can be found in the financial reports of the company in the Balance Sheet Liability section.
Note that not always the fact that the company has certain debts is negative for it. Loaned money facilitats restructuring, development, mastering new technology, and expanding the business. All this can potentially yield a profit. In short, even huge and successful corporations sometimes loan money for business development.
- When D/E is zero, the company does not use loaned money, only its own assets. This is not always a good sign. We can conclude that the management is cautious about finance and in the future the company might make less profit than it could. As a rule, such companies develop slowly, but enjoy market stability. Your invested money will bring a modest yet constant profit.
- Above zero: this means that the company does loan some money. With such D/E, companies can potentially increase their profits. However, you need to know what they spend the loaned money on. The company might be covering up older debts, getting deeper in financial trouble. Nonetheless, companies tend to use their loans wisely.
- Above one: the company loans more money than it has. If it does not have enough to pay off its debts, it might end up as a bankrupt.
The answer depends on the sector that the company works in. The conditionally optimum level is 0.5-0.7. This means that the company uses the financial leverage correctly and has some future. In exceptional cases, the optimum D/E is taken as 1.
The advantages are:
- It helps to compare companies by the ratio of their own money and debts;
- It shows whether the company loans money rationally;
- It demonstrates the solvency of the company;
- It helps to assess the perspectives for the development of the company.
- It does not allow comparing companies from different sectors;
- It seriously differs for companies from the same sector but different countries;
- It needs fresh info about liabilities and assets that is normally published once in a quarter.
The Debt to Equity ratio demonstrates the ratio of the liabilities of the company to its equity. As an indicator it has advantages and disadvantages and must be used alongside others when assessing investment options.
Keep in mind that liabilities larger than the equity are not always bad. Loans, especially long-term ones, provided they are used wisely, help the company develop and increase profits.