The debt-to-equity ratio is a calculation used to measure the capital structure of a business. In simple terms, it is a way of examining how a company uses different sources of funds to fund operating costs. The ratio measures the proportion of assets funded by debt to assets funded by equity or capital. The debt-to-equity ratio is also referred to as the risk ratio or solvency ratio, as a quick way to determine the financial solvency used by the company. In other words, this calculation gives an idea of how much a company uses debt to fund operational activities. This calculation also helps understand a company's exposure to increased interest or insolvency (bankruptcy rate).
Step
Part 1 of 2: Performing Basic Analysis and Calculations
Step 1. Determine the company's debt and equity values
Find the information needed to make these calculations on the company's balance sheet. Previously, you had to decide which balance sheet account to include in the debt calculation.
- Equity or capital refers to the funds attributable to shareholders (stockholders), plus the company's income. The company's balance sheet statement must include the number marked as total capital.
- When determining the value of debt, include interest payable, long-term debt such as notes payable and bonds. Also be sure to include the amount of long-term current debt. This can be found in the current accounts payable section of the balance sheet statement.
- Analysts often exclude current liabilities such as notes payable and accrued payables. These items provide little information about the level of solvency of a company. This is because they do not reflect long-term commitments, other than the day-to-day operations of doing business.
Step 2. Be aware of expenses that are not listed on the balance sheet
Sometimes companies don't include expenses in their balance sheets, to make their capital-debt ratio look better.
- You must include a number of liabilities off the balance sheet when calculating debt. Operating lease expenses and unpaid pensions are the two most common off-balance sheet liability items. These costs are often large enough to be included in the calculation of the debt-to-equity ratio.
- Other debts that must be considered can come from joint ventures or research and development-based partnerships. Scan all records in the financial statements and look for liabilities recorded outside the balance sheet. Include everything that is worth above 10% of the total interest payable.
Step 3. Calculate the debt-to-equity ratio
Find the value of this ratio by dividing total debt by equity. Start with the section identified in Step 1 and plug it into the following formula: Debt-to-Equity Ratio = Total Debt Total Equity. The result is a debt-to-equity ratio.
For example, suppose a company has a long-term interest debt of Rp. 4,026,840,000, -. The company also has a total capital of Rp13,422,800,000, -. Thus, the company has a debt-to-equity ratio of 0.3 (4,026,840,000 / 13,422.8 million), which means that the total debt is 30% of the total capital
Step 4. Perform a basic assessment of the firm's capital structure
Once you've finished calculating your company's debt-to-equity ratio, you can start developing ideas about its capital structure. Here are a few things to keep in mind:
- A ratio value of 0.3 or less is considered healthy by many analysts. But in recent years, many have concluded that solvency that is too small is as bad as solvency that is too large. Solvency that is too small means that the management does not dare to take risks.
- A ratio value of 1.0 indicates that the company finances its projects with a balanced mix of debt and equity.
- A ratio value of more than 2.0 indicates that the company borrows a lot to fund operational activities. This means that creditors have twice as much money in the company as capital holders.
- A lower ratio means that the company has less debt, and this reduces risk. Companies with less debt are also less exposed to the risk of rising interest rates and changes in credit conditions.
- Some companies will still choose debt-based financing even though they know the risks are also increasing. Debt-based financing allows companies to gain access to capital without impairing ownership status. Sometimes this also leads to higher income. If a company with a lot of debt turns profitable, a small number of owners will make a lot of money.
Part 2 of 2: Analyzing Deeper
Step 1. Consider the financial needs of the industry in which the company operates
As noted above, the high debt-to-equity ratio (above 2.00) is worrying. This ratio gives a dangerous amount of leverage or solvency. However, in some industries, a high debt-to-equity ratio is considered appropriate.
- For example, construction firms use construction loans to fund most of their projects. Although this refers to a high debt-to-equity ratio, the firm is not exposed to bankruptcy risk. The owner of each construction project basically pays to service the debt.
- Financial firms may also have high debt-to-equity ratios because they borrow money at low interest rates and lend at high interest rates. Another example is capital-intensive industries such as manufacturing or manufacturing companies. These companies often borrow money to buy raw materials for processing in factories.
- Industries that do not demand capital intensive may have lower debt-to-equity ratios. Examples include software providers and professional service firms.
- To assess whether a company's debt-to-equity ratio is within reasonable limits, it's a good idea to compare it with other companies in the same industry, and/or with the debt-to-equity ratio in the previous period.
Step 2. Consider the effect of treasury stock on the debt-to-equity ratio
The repurchase of treasury shares reduces the shareholder's capital account. This can result in a massive increase in the debt-to-equity ratio.
- The purchase of treasury shares reduces shareholder capital and consequently increases the debt-to-equity ratio. However, the overall impact on shareholders may be beneficial. This is because other shareholders receive a larger share of net income and dividends, without an increase in debt burden.
- Financial solvency is enhanced by the purchase of treasury shares. At the same time, operational solvency (ratio of variable and fixed costs) did not change. In other words, production costs, prices and profit margins are not affected.
Step 3. Consider calculating the debt service coverage ratio
When a company has a high debt-to-equity ratio, many financial analysts turn to debt service coverage ratios. This adds further information about the company's ability to pay its debts.
- The debt service coverage ratio divides the company's operating income by the ability to pay debts. The greater the yield, the greater the company's ability to have sufficient income and pay debts.
- The ratio value of 1.5 or more is the industry's minimum limit. A low debt service coverage ratio, combined with a high debt to equity ratio, should be taken into account by every investor.
- High operating income allows companies that are drowning in debt to pay off their debts.
