Debt to Equity Ratio

The capital structure of a company determines how the company finances its operations. Companies rely on long-term debt, short-term debt, common equity, and preferred equity for meeting their capital requirements. The popular ways of raising debt and equity is by issuing bonds and stocks, respectively.

Stockholders are the owners of the company, while bondholders are the creditors. Bondholders are entitled to interest, while stockholders receive dividends on a regular basis.

Analyzing the debt to equity ratio can help investors understand the capital structure of a firm and the impact of managerial decisions, viz. using additional financial leverage, or issuing more shares on the growth prospects of the company. To facilitate comprehension, undermentioned is the definition, formulae, and interpretation of the said concept.

The debt to equity ratio is a measure of the degree of financial leverage employed by the firm. It is defined as the ratio between total liabilities (or total debt) and shareholders' equity.

One must bear in mind that, although the terms debt and liabilities are used interchangeably, there are differences between the two. These differences have given rise to popular variations of the debt to equity formula.

In general, one may say that companies having a high ratio, may find it difficult to avoid bankruptcy in the event of being unable to repay the interest on the borrowed sum, or discharge their financial obligations.

The formulae for calculating the ratio are as follows:

Debt to Equity Ratio = Total Liabilities / Shareholders' Equity

Or

Debt to Equity Ratio (Total Ratio) = (Long-Term Debt + Short-Term Debt) / Shareholders' Equity

Sometimes, the ratio between long-term debt and shareholders' equity may also be referred to as the debt to equity ratio. However, Long-Term Debt / Shareholders' Equity is generally known as the long-term debt to equity ratio.

The difference between total debt and total liabilities is as follows: Total liabilities include short and loan-term debt and operational liabilities.

Operational liabilities refer to short-term liabilities, like accounts payable, wages payable, pension obligations, income-tax payable and similar obligations. These are non-interest bearing liabilities that are subtracted from total assets to arrive at net operating assets.

Total debt, on the other hand, includes interest bearing liabilities that may have a maturity period of less than or greater than one accounting year. Debt obligations with maturity periods exceeding one year, come under long-term debt. Notes and bonds are common examples of long term debt.

Short-term debt has a maturity of less than one accounting year and includes short-term loans from the bank, commercial paper, etc.

Shareholders' equity is calculated using the following formula:

☛ Shareholders' equity = Share Capital + Retained Earnings_{year end} - Treasury Stock

☛ Retained earnings_{year end} = Retained earnings_{year beginning} + Net Income_{year end} - Dividends

Share capital refers to preferred stock, common stock and additional paid-in-capital. The additional paid-in-capital can be raised by issuing both common and preferred stock and it refers to the contributions made by the investors over the par value of the stock.

Treasury stock includes shares that are repurchased by a company as well as stock that is retained by a company at a time, when the shares are initially offered to the public.

The reason for maintaining a treasury stock can be attributed to the company's desire to retain a controlling interest in the firm. Sometimes, shares may be repurchased for retiring the stock or for reissuing shares at a later date, when the need for capital surfaces.

In order to interpret a financial ratio, one must compare the ratio across time, between peers or study it in relation to a benchmark. A company's debt to equity ratio should be compared with its ratio in the past to assess changes in the company's capital structure.

The ratio should be analyzed in relation to the average ratio for the industry to which the firm belongs. On comparing company's debt to equity ratio with the industry benchmark, or with the debt to equity ratio of similar firms, one can know the extent to which the firm is employing leverage and get a view on the degree of risk undertaken by the company.

A debt to equity ratio that scales on the higher side indicates the company's inability to generate cash and in turn meet its debt duties. A low debt to equity ratio may depict an all-together different story. It may show that the company is lax about its financial status, thus not actively participating in using the profit incurred to their advantage.

It is a valid proposition to compare the debt to equity ratio, when companies share the industry profile; for instance, an industry with low capital must not be compared with a high-capital industry.

The debt to equity ratio is found to be higher, when it comes to industries that require high capital investments. For industries that are capital intensive in nature, investments are conducted on a larger scale, as compared to industries that are based on low capital.