Debt-equity ratio is the measurement of the financial leverage of a company. Financial leverage refers to the extent of utilization of a company’s borrowed money. Debt-equity ratio denotes long term debt which is divided by common shareholders’ equity (total assets without liabilities). Usually the previous fiscal year’s data is utilized for calculation. Investment in a company which has a higher debt-equity ratio is riskier in periods of skyrocketing interest rates, when additional amount of interest has got to paid in relation to the debt.
Let us make this clear with an illustration. Suppose the long term debt of a company is $3000, and the shareholder’s equity is $12000, then 0.25 is the debt-equity ratio (3000/12000). Debt-equity ratio higher than 1 signifies that most of the assets are financed by incurring debt. If it is less than 1, it will signify that assets have primarily been financed by equity.
Debt-equity ratio explained
There are great deals of variations which may be considered while finding the debt-equity ratio. As for instance, majority of times, liabilities only signify long term debts, like debt which has been taken with the help of bonds and other types of business loans. Another example is preferred stock. While determining the debt-equity ratio, this may be taken as a liability or an asset.
Companies may have different other forms of liabilities like those which are listed in the ledger containing accounts payable which sometimes are counted as liabilities, and often not, for calculation of debt-equity ratio. In quite a few of the cases, these frequently change and thus may not provide an adequate picture of the liabilities of a company. Whether these are to be used or not rests purely upon the discretion of the company.
On account of the fact that not each company compares same things while offering a debt equity ratio, investors should be cautious. Apparently, one company may seem better compared to another. An investor should understand the fact that the look is on the basis of what items are being listed by that particular company as debt and equity.
Use of debt-equity ratio
Investors use the debt-equity ratio in order to determine the extent of the risk involved in purchasing equity through stock in the company, or buying bonds which the company issues. Companies having higher debt-equity ratio will have to issue higher rate of interest to entice investors into purchasing bonds.
Companies wishing to keep the stock prices over a specific level or participate in the bond market must closely keep a track of their debt-equity ratio. On quite a few occasions with an effort to improve the debt-equity ratio, certain companies have been successful in paying off burdens of long-term debt.
Liquidating of assets is an effective way of reducing interests on debt payments and allowing equity to build up quickly. However it must be remembered that bringing about substantial improvement in debt-equity ratio by a company cannot be done overnight, but must take place gradually over time.