Historical Background to the Debt to Equity Ratio
The Debt to Equity ratio has historically been quoted and used by most industry investors as a quick method of analysing how much has been invested by the company’s shareholders.
The ratio explains the proportion of Debt and Equity that the company is using to finance its operations. The company Debt to Equity ratio is then compared to industry benchmark Debt/Equity ratios.
The Debt to Equity ratio is also widely quoted in the financial press.
What is the Debt to Equity Ratio?
The first thing to consider is that there are many definitions for the Debt to Equity ratio. The first calculation for the Debt to Equity ratio is calculated for a quoted company as:-
- “Debt to Equity Ratio” = “Total Liabilities /Shareholders Equity”
An alternative calculation used by industry investors only the long-term liabilities (since it could be argued that short-term liabilities have little to do with the financing of a company. This definition is:-
- “Debt to Equity Ratio” = “Long-Term Liabilities /Shareholders Equity”
There are other definitions but these are possibly the main 2 Debt/Ratio ratios.
What Does the Debt to Equity Ratio Mean to Industry and the Investor?
Industry and investors will often look at the relative size of the Debt to Equity ratio. This is because a high Debt to Equity ratio implies that a company has an relatively higher commitment to pay fixed interest charges.
Why does Industry View the Debt-to-Equity Ratio as important?
Investors may find it useful to compare the Debt to Equity ratio of a company compared to that of the industry and comparative companies. This helps to provide a relative gauge of how the company is perceived from a risk perspective.
N.B. the Debt to Equity ratio is only an indicator and often raises more questions, however it is still an important financial ratio. Historical Debt to Equity ratio analysis also provides useful data, since this historical analysis when compared with the industry analysis can help provide some insights into the historical risk level of the business.
What are the Key Problems with Debt-to-Equity Ratio Analysis of a Company or an Industry?
Three possible key problems with the Debt-to-Equity ratio calculation are:
- Investors & industry place too much emphasis on the Debt-to-Equity ratio.
- Investors & industry often do not carry out deep fact based comparative analysis (investors often compares ratios which have used different definitions).
- Investors & industry must be crystal clear on which definition they are using (for example if the second calculation above is used, then what defines a long-term liability?)
What are the Secondary Problems with Debt-to-Equity Ratio Analysis of a Company or an Industry?
Possible secondary problems with the Debt-to-Equity ratio include the following:-
- Debt to Equity ratios use historical data. Historic data is not always a sound basis for future earnings
- The Debt to Equity can vary due to short-term influences
- Investors will find that Debt to Equity ratios tend to be industry specific
What is Considered a Good Debt to Equity Ratio? What is an Acceptable Debt to Equity Ratio?
It is difficult to assess if any ratio (including the debt-to-equity calculation) is good or bad without assessing the industry, comparable businesses and also the strategy of the organisation. However one possible view is that debt-to-equity ratios which are less than one and greater than one can be grouped together, it is however always critical to take professional investment advice before making any decisions.
Is a Debt to Equity Ratio of Less than One Considered Bad?
Having Relatively Low Financial Gearing
A debt to equity ratio calculation less than one shows that the company has more shareholder equity than debt (or long-term debt depending on the definition).
Is a Debt to Equity Ratio of More than One Considered Good?
Having a relatively high gearing level
A debt to equity ratio greater than one explains that the company is mainly financed by debt. This is possibly interpreted as having a higher risk when compared with a similar company with a lower ratio. There are however some benefits to having higher debt, since the interest payments are usually tax deductible (whereas dividends are usually not tax deductible). Professional investor advice must be taken before investment decisions are taken.