Financial ratios are of great importance to every business. These ratios measure the performance of the business so that it can be evaluated in order to improve performance in the coming years. Among the many ratios in accounting one is debt to equity ratio. This ratio measures that how much of the company’s assets are financed by using debt or by equity. It’s calculated by dividing debt with equity. However, it depends on what the company regards to be debt which might lead to changes in the formula. The answer can either be in percentage or in numbers depending on the company’s need.
Debt to equity ratio is also at time referred to as the gearing ratio. Since it checks the financial leverage of the company, how much of it is financed by owner or creditor. A higher gearing ratio is not usually regarded as a good sign for the business.
Equity is when money for business purposes is borrowed from investors for instance, share holder’s equity. However, this comes up with the condition that investors will need to be given a part of ownership or control of the business which leads to a greater potential of conflict. Equity financing is less risky, it helps individuals who have credit problems and most importantly such investors (lenders in this case) do not require an immediate return. They may be at a risk of losing the money they had invested if the business fails.
Debt on the other hand means that no ownership will have to be given to anyone money can be borrowed from the bank for example. However, all businesses may not qualify for the bank loan and the cost of interest payments and principle payments may be quite high.
A higher debt to equity ratio means that the firm has been increasing its assets by financing them through debt rather than equity; owner’s equity or shareholders. This generally means that the company is more risky since it has high debt to repay along with interest payments.
However, it is worth considering that at time a company generates a huge amount of earnings only because it took the debt. If these earnings turn out to be greater than the debt amount plus interest payments, then the shareholders are definitely better off. Since greater amount will be available to distribute among the shareholders as dividends.
In case the result of taking debt doesn’t turn out to be favorable then it is really harmful for the company. As the share values may take a hit or in extreme circumstances the company might be bankrupt which may leave nothing for the shareholders because the creditors are paid first.
When this ratio is used for personal finances then equity refers to the difference between the total assets and total liabilities of that person. Thus the formula that is used is Total personal debt divided by (Total assets- total liabilities). This is usually used by individuals when they are applying for a loan so that they have an idea of how much debt they have in terms of each dollar of equity. Lenders too can make great use of debt to equity ratio since the result can tell if the person will be able to repay the loan or not.
When analyzing the results of this ratio it is really important to consider the sort of industry the company is operating in. Since it is common for some company’s belonging to a specific industry to have a lower debt to equity ratio. This difference arises due to the difference between capital intensive industries and labor intensive industries. The former is where higher level of capital is employed by the firms because that is the most rational decision in accordance with their firm. Whereas the latter is where more labor is employed comparatively. Hence, the ratio of capital intensive firms is usually higher and vice versa.
Moreover, the definition of liabilities can be different for different firms. Some might only include debts, securities while others may also include unearned revenue as a liability. Unearned revenue means the firm has received the money for a service that yet has to be offered hence it’s a sort of liability on the firm.
In other cases, some firm may differentiate between long term and short term debts. For instance some firms may only choose to include long term debts while the other might include all the debts.
Because of all the reasons mentioned above if comparison is to be made between companies it’s important to follow the same rules when it comes to including debts and equity. Furthermore, decisions should never be based on just assessing one ratio; other ratios should also be considered to get a better picture.
