A company’s debt-to-equity ratio is a measure of the the amount of capital provided by shareholders compared with the amount of capital provided by creditors. Often abbreviated to D/E, it’s calculated by dividing a company’s total liabilities by its stockholders’ equity, thus showing the extent to which shareholder equity can fulfil the company’s obligations to creditors in the event of it going bust.
Understanding the debt-to-equity ratio
In general, a high debt-to-equity ratio may be an indication that a company is unable to generate enough money to meet its debt obligations. However, this doesn’t mean that having a low debt-to-equity ratio is necessarily a good thing – in fact, this might suggest that a company isn’t taking advantage of the increased profits that financial leverage may bring.
While a debt-to-equity ratio is a useful tool for assessing a company’s financial health, you must take into account external factors that may influence its meaningful interpretation. For instance, it is usual for companies in capital-intensive industries to express a higher D/E ratio than those in low-capital industries, since they must spend money on equipment, property, plants etc in order to operate. This means that comparing a company in a capital-intensive industry with one in a low-capital industry can present skewed results. To draw the most meaning from a D/E ratio, compare it with businesses operating within the same industry.
The debt–equity ratio formula can vary, so it pays to understand the types of debt and equity being used in the D/E calculation in question.
What is debt?
Debt is the amount of money raised through a bank loan or some other financial instruments such as a mini-bonds. Normally it is for a defined period; in the case of a mini-bond this is three or four years. Debt financing is typically raised for a particular purpose and is often secured against collateral of some kind.
What is equity?
Equity is finance that is provided in exchange for a share in the ownership of the company and also a share in any future profits. Equity finance can come from a variety of sources and may include money invested by the owner or founder and funds from business angels or venture capitalists. In more recent years, equity has grown to include investments from individuals obtained through equity crowdfunding platforms such as SyndicateRoom. Equity is often raised to provide for the company’s longer term needs and for general use.
What is the optimal ratio of debt-to-equity for a business?
The optimal ratio of debt to equity varies by company and across industries. Some companies attract equity investment more easily than others and certain industry sectors such as construction and the oil and gas industry are more capital-intensive than other sectors. The life-stage of a company can also impact its ability to raise capital, with startup businesses less able to borrow because they have few if any assets and an uncertain cash-flow.
How is the debt-to-equity ratio calculated?
The debt-to-equity ratio is calculated by taking a company’s total debt and dividing it by its equity to arrive at the D/E ratio which is often expressed as percentage. If a company has high level of debt it will be said to have a high debt-to-equity ratio – also known as being ‘highly geared’.
The debt-to-equity ratio and ‘gearing’
A high level of gearing often means better returns for shareholders when the economic climate is favourable. However, when times are hard – highly geared companies have the added problem of paying interest on their debt. In those same hard times a company with a low level of gearing may suffer less as they can choose not to pay a dividend to their shareholders.
Having little or no debt may not be ideal, as by doing so a business could be constraining its growth. In today’s more cautious economic climate there is a general belief that debt and equity should be equal – i.e. a ratio of 1:1 or even 1:2 in favour of equity.
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