Debt/Equity Ratio What Does Debt/Equity Ratio Mean? A measure of a company’s financial leverage calculated by dividing its total liabilities by its stockholders’ equity; it indicates what proportion of equity and debt the company is using to finance its assets. http://financial-dictionary. thefreedictionary. com/debt%2Fequity+ratio ‘Debt/Equity Ratio’ A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense.
If a lot of debt is used to finance increased operations (high debt to equity), the company could potentially generate more earnings than it would have without this outside financing. If this were to increase earnings by a greater amount than the debt cost (interest), then the shareholders benefit as more earnings are being spread among the same amount of shareholders. However, the cost of this debt financing may outweigh the return that the company generates on the debt through investment and business activities and become too much for the company to handle. This can lead to bankruptcy, which would leave shareholders with nothing.
The debt/equity ratio also depends on the industry in which the company operates. For example, capital-intensive industries such as auto manufacturing tend to have a debt/equity ratio above 2, while personal computer companies have a debt/equity of under 0. 5. Read more: http://www. investopedia. com/terms/d/debtequityratio. asp#ixzz2DQ7bp1aa The debt to equity ratio is a financial metric used to assess a company’s capital structure, or “capital stack. ” Specifically, the ratio measures the relative proportions of the firm’s assets that are funded by debt or equity.
The debt to equity ratio (also called the risk ratio or leverage ratio) provides a quick tool to financial analysts and prospective investors for determining the amount of financial leverage a company is using, and thus its exposure to interest rate increases or insolvency. Knowing how to analyze the debt to equity ratio can help you assess a company’s financial health before investing. Steps 1. 1 Determine the debt to equity ratio for the company in question. The ratio is calculated simply by dividing the firm’s total debt by its total shareholder’s equity.
These balances can be found on the company’s balance sheet. Ads by Google Free Annuity Calculator Up To 40% More Income To Retire On. Try Our Free Online Calculator Now! AgePartnership. co. uk/Annuity-Report * Generally, only interest-bearing, long term debt (such as notes payable and bonds) is included in the ratio’s calculation. Short-term liabilities, such as accounts payable, are often left out, as they don’t provide much information about the company’s use of leverage. * Some large, off-balance sheet liabilities should be included in the ratio’s calculation, however.
Operating leases and unpaid pensions are 2 common off-balance sheet liabilities that are large enough to warrant inclusion in the debt to equity ratio. 2. 2 Perform a cursory assessment of the firm’s capital structure. Once you have determined the debt to equity ratio for a particular company, you can get an idea of their capital stack. A ratio of 1, for example, indicates that the company funds its projects with an even mix of debt and equity. A low ratio (below about 0. 30) is generally considered good, because the company has a low amount of debt, and is therefore exposed to less risk in terms of interest rate increases or credit rating. . 3 Consider the financing needs associated with the specific industry in which the firm operates. Generally, a high debt to equity ratio (2, for example) is worrisome, as it indicates a precarious amount of leverage. However, in some industries this is appropriate. Construction firms, for example, fund their projects almost entirely with debt in the form of construction loans. This leads to a high debt to equity ratio, but the firm is in no real risk of insolvency, as the owners of each construction project are essentially paying to service the debt themselves. . 4 Determine the effect of treasury stock on the debt to equity ratio. When a company issues stock, shares are usually held on the balance sheet at par value (often only $0. 01 per share). When the firm buys back stock, the treasury stock is recorded at the purchase price; this results in a massive subtraction from shareholder’s equity, increasing the debt to equity ratio. A troublingly high debt to equity ratio may simply be the result of stock buybacks. 5. 5 Augment your analysis with other financial ratios. The debt to equity ratio should never be used alone.
For example, if a company’s debt to equity ratio is quite high, you might reasonably worry about their ability to service their debt. To address this concern, you can also analyze the firm’s interest coverage ratio, which is the company’s operating income divided by debt service payments. A high operating income will allow even a debt-burdened firm to meets its obligations. Capital Structure Total Debt to Total Equity 40. 13 Total Debt to Total Capital 28. 64 Total Debt to Total Assets 17. 66 Long-Term Debt to Equity 31. 57 Long-Term Debt to Total Capital 22. 53