What is Debt Equity Ratio?
The debt-equity ratio helps in evaluating the financial leverage of a company. It is derived by dividing the total liabilities of a company by the shareholder’s equity. Such numbers are available on the financial statements of the company. The ratio measures the degree by which the company is financing its various operations majorly through debt vs wholly-owned funds. It reflects how the shareholders’ equity can cover the outstanding debts of the company in case there is a business downturn.
How To Calculate Debt Equity Ratio
Debt/Equity Ratio = Total Liabilities ÷ Total Shareholder’s equity
High leverage ratios mean that the company or stock is of a higher risk to its shareholders. D/E ratio is at times tough to compare through different industry groups since ideal debt amounts tend to vary. Investors can modify this ratio so that there is an increase in focus on long-term debt as the long-term liabilities risk is different from short term payables and debt.
D/E shows an impact due to changes in long-term debts & assets. This is because of comparatively large amounts of such debts in comparison to short-term assets and debt. For a better analysis of D/E ratios, investors can include profit performance, short-term leverage ratios, and growth expectations figures.
Real Stock Debt Equity Ratio
Apache Corp or APA had $13.1 billion total liabilities at the end of 2017. It had $8.79 billion as total shareholder equity. Its debt ratio was 1.49.
ConocoPhillips or COP had $42.56 billion total liabilities at the end of 2017. Its shareholder equity was $30.8 billion. Its debt-equity ratio was 1.38.
As seen, APA had a higher leverage ratio which means higher risk. But, at this stage from the available figures, the information is not enough to make decisions and more research is needed.
On reclassifying preferred equity, D/E ratio changes in the below example.
There is an assumption that the preferred stock of the company is $500,000. There is $1 million total debt which excludes preferred stock. There is $1.2 million total shareholder equity which excludes preferred stock.
Debt/Equity = $1 million + $500,000 ÷ $ 1.25 million = 1. 25
(With preferred stock a part of total liabilities)
Debt/Equity = $1 million ÷ $1.25 million + $500,000 = .57
Unearned income & similar financial accounts can be considered debt & can change the D/E ratio. For instance, a company has a prepaid contract for a building construction worth $1 million. For some reason, the work stops and $1 million becomes a liability.
How Debt Equity Ratio Helps to Value a Stock
The debt to equity ratio is a formula to depict how capital is raised for running a business. It is a significant financial metric as it indicates the stability of the company. It is also an indication of how the company raises additional capital. The ratio is important for investors, as it indicates how risky it is to invest in the stocks of the company. The higher the ratio the greater is the risk.
The debt-equity ratio represents the debt of a company as a % age of the shareholder’s equity. If this ratio is <1, the firm is less risky than the firms whose debt to equity is higher than 1.0. If the debt-equity ratio is .50, it signifies that the company uses 50 cents of debt financing for $1 of equity financing.
A good debt-equity ratio is generally between 1 to 1.6. But the ideal ratio tends to vary from one industry to another, as many industries use additional debt financing. A few capital-intensive industries which include manufacturing and financial industries have high ratios, sometimes more than 2.
When the debt-equity ratio is high, it means that the business uses debt for financing its growth. Generally, companies that put in huge money in operations and assets have a higher debt-equity ratio. In the case of stock investors and lenders, this high ratio signifies higher risk. This is because the firm might not have enough money for repaying its debt.
In case of a low debt-equity ratio, it means that the business does not rely on borrowing for financing its operations. Investors might not prefer investing in such companies as the business is not realizing profits or the value it could gain by increasing its operations or by borrowing.
However, investors need to realize that this ratio can be misleading at times if it is not used with other industry ratios and financial information. It helps in determining how the company is using its equity and debt in comparison to others.