When measuring the health of a company, it is essential to examine the financial standing of the company. The Debt-equity ratio or risk ratio or gearing is a leverage ratio that can evaluate the company’s financial leverage. It is used to calculate the weight of total debt and financial liabilities against total shareholders’ equity.
What is the Debt to Equity Ratio?
– The debt-to-equity ratio used to measure a company’s ability to repay its obligations.
– The debt/equity ratio shows the health of a company. In case of a higher ratio, the company is getting more financing by borrowing money subject to risk if potential debts are too high, which can lead to company bankruptcy during hard times.
– Lenders and investors generally prefer low debt-to-equity ratio because their interests are better protected during a business decline.
– The debt-to-equity (D/E) ratio compares a company’s total liabilities to its shareholder equity and can be used to evaluate how much leverage a company is using.
– Higher leverage ratios tend to indicate a company or stock with higher risk to shareholders.
– However, the D/E ratio is difficult to compare across industry groups, where ideal amounts of debt will vary.
– Investors will often modify the D/E ratio to focus on long-term debt only because the risk of long-term liabilities are different than for short-term debt and payables.
How is Debt-to-equity Ratio Calculated?
To start calculating the debt-to-equity ratio, you have to divide the total debt owed by the company by the shareholders’ equity.
Debt-to-equity ratio = Liabilities / Equity
The liabilities include short term debts, long term debts and fixed payment obligations.
How does a debt to equity ratio work?
A high debt to equity ratio can be associated with increased risk. If the ratio is high, it means that the company is borrowing capital to finance its growth. Lenders and investors often lean towards the companies which have a lower debt to equity ratio.
The debt to equity ratio should be compared to the data from other financial years. If there is a sudden increase in a company’s D/E ratio, it can mean that the company has a growth strategy that it is aggressively funding through debt. The ratio should be compared with the average ratios to avoid misinterpretation. Capital intensive companies tend to have a higher DE ratio than service firms.
Limitations of the D/E Ratio:
– A debt-to-equity ratio of 1 is considered to be optimal, i.e. liabilities = equity. This ratio is very industry-specific as it depends on the proportion of current and non-current assets. Capital intensive companies will have a higher DE than service companies.
– The maximum acceptable debt-to-equity ratio for more companies is between 1.5-2 or less. For larger companies, a value higher than 2 of the debt-to-equity ratio is acceptable.
– In general, a high debt-to-equity ratio indicates that a company may not be able to generate enough cash to satisfy its debt obligations. However, a low debt-to-equity ratio may also mean that a company is not taking advantage of the increased profits that financial leverage may bring.
Risk of High Debt-to-Equity Ratio:
– If a company’s D/E ratio is very high, any incurred losses will be compounded, and the company may not be able to repay its debt.
– If the D/E ratio gets too high, then the cost of borrowing will rapidly increase, as will the cost of equity, and the company’s WACC will get too high, driving down its share price.
Benefits of High Debt-to-Equity Ratio:
– A high debt-equity ratio shows that a firm can efficiently fulfil its debt obligations through the company’s cash flow and is using the leverage to increase equity returns and strategic growth.
– Using more debt raises the company’s return on equity (ROE). The equity account is smaller, and returns on equity are higher if the debt is used instead of equity.
– The cost of debt is often lower than that of equity, and therefore increasing the D/E ratio up to a certain point can lower a firm’s weighted average cost of capital (WACC).
What is the equity market and how does it work?
Equity markets are a vital component of the market economy. It facilitates investors to invest in shares of companies. When a company ‘goes public’ through an initial public offering (IPO), it lists itself on the equity market. Thereafter, investors may buy and sell the shares in the stock exchanges of the equity market. One thing to note here is that equity shares may be issued and traded through over-the-counter markets too. In cases where companies do not want to list and be publicly traded, but want to raise money from investors, shares are issued through the OTC market.
Returns you can earn and risks involved in equity market
Equity is one of the most popular investment avenues because of its potential to yield returns. When people buy shares, they hope the prices will go up and that they will be able to sell it at a higher price to pocket the difference as profit. Price movements happen by the seconds in the stock market, and the equity markets across the world have traditionally yielded double-digit yearly returns. This is the basis for the belief that the potential for returns is higher in equity than other investment avenues such as debt.
Another key advantage of equity investment is that stocks may add to income through dividends, should the companies you invest in decide to share their profit with the shareholders. However, there are no guarantees in the equity market.
Equity is considered one of the riskiest asset classes to invest in. The prices of stocks are highly volatile; even industry stalwarts cannot predict or time the stock market. Remaining invested for the longer term helps to tide over short-term market fluctuations while your money accumulates earnings.
The attraction for equity comes from the fact that the higher the risk, the higher is the potential for returns.
Who can consider investing in equity?
An investor with the following characteristics can consider the equity market to make investments:
– If you have a longer investment horizon – more than 5 years preferably.
– If you have enough funds to spare, losing which will not dent your personal finances
– If you have a suitable risk profile with an appetite for high risk
– If you have the time to conduct research and take informed decisions
– If you are patient enough to withstand the volatile cycles of the market and remain invested
Careful study of a company’s financial statements and analysis of valuations are important when investing in equity markets. You may want to reach out to an experienced financial advisor before dipping into the equity markets.
Conclusion
The risk-reward of equity and debt are what sets them apart fundamentally. Liquidity and maturity periods modify their functionality. While both are great investment avenues, the choice of the asset class or a mix of these should become part of your investment portfolio only after you assess your risk profile. Read up about them and reach out to a financial advisor to make informed choices.
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