Definition
Debt-to-Equity Ratio,often referred to asGearing Ratio, is the proportion ofdebtfinancing in an organization relative to itsequity.
Formula
Debt-to-Equity Ratio has several variations. Most popular ones are as follows:
Debt-Equity Ratio1 | = | Debt |
Equity | ||
Debt-Equity Ratio2 | = | Long-Term Debt |
Equity | ||
Debt-Equity Ratio3 | = | Long-Term Debt |
Equity + Long-Term Debt | ||
Where:
- ‘Debt’ is thebook or market valueofinterest-bearing financial liabilitiessuch as debentures, loans, redeemable preference shares, bank overdrafts and finance lease obligations.
- ‘Equity’ is the book value of share capital and reserves (i.e. equity section of the balance sheet) or the market value of equity shares (i.e. market capitalization).
Should Debt-Equity Ratio be calculated using market values or book values of debt and equity?
Both market values and book values of debt and equity can be used to measure the debt-to-equity ratio. Arguably, market value (where available of course) provides a more relevant basis for measuring the financial risk evident in the debt-to-equity ratio.
This is because book values of assets (and hence equity) are usually lower than their market value (e.g. due to historical cost convention and impairment losses) whereas the book value of debt remains relatively close to its market value (e.g. interest on bank loan is usually adjusted periodically in line with prevailing market interest rates). This can cause an inconsistency in the measurement of the debt-equity ratio because equity will usually be understated relative to debt where book values are used. Using market values for both debt and equity removes such inconsistencies and therefore provides a better reflection of the financial risk of an organization.
Which liabilities should be included in calculation of debt in a debt-equity ratio?
As debt-equity ratio is a measure of financial risk, it makes more sense to calculate the ratio using only finance-related liabilities (i.e. interest-bearing liabilities) such as borrowings from financial institutions, debentures, redeemable preference shares and finance lease obligations.
Where long-term debt is used to calculate debt-equity ratio it is important to include the current portion of the long-term debt appearing in current liabilities (see example).
Liabilities that are not related to financing activities of an organization (e.g. accrued liabilities, trade payables, tax liabilities, etc.) may be excluded from the calculation of debt because they usually do not affect the financial risk of an organization significantly and any liquidity risk that such liabilities may pose can more effectively be measured under liquidity ratios.
Example
ABC PLC
Statement of Financial Position as at 31st December 2020
| 2020 | |
|---|---|
USD | |
Assets | |
Non-current assets | |
Property, plant & equipment | 130,000 |
Goodwill | 30,000 |
Intangible assets | 60,000 |
220,000 | |
Current assets | |
Inventories | 12,000 |
Trade receivables | 25,000 |
Cash and cash equivalents | 8,000 |
45,000 | |
Total assets | 265,000 |
Equity and liabilities | |
Equity | |
Share capital | 100,000 |
Retained earnings | 50,000 |
Revaluation reserve | 15,000 |
Total equity | 165,000 |
Non-current liabilities | |
Long term borrowings | 15,000 |
Deferred tax | 8,000 |
Finance Lease Obligation | 12,000 |
Current liabilities | |
Trade and other payables | 35,000 |
Short-term borrowings | 10,000 |
Current portion of long-term borrowings | 15,000 |
Current tax payable | 5,000 |
65,000 | |
Total liabilities | 100,000 |
Total equity and liabilities | 265,000 |
Calculate debt-to-equity ratio of ABC PLC.
Debt-Equity Ratio1 | = | Debt |
Equity | ||
= | 52,000 (W1) | = | 0.32 | |
165,000 | ||||
Debt-Equity Ratio2 | = | Long-Term Debt |
Equity | ||
= | 42,000 (W2) | = | 0.25 | |
165,000 | ||||
Debt-Equity Ratio3 | = | Long-Term Debt |
Equity + Long-Term Debt | ||
= | 42,000 (W2) | = | 0.20 | |
165,000 + 42,000 | ||||
| Working 1: Debt | USD |
|---|---|
Non-Current portion of long-term loan | 15,000 |
Current portion of long-term loan | 15,000 |
Deferred Tax | - |
Finance Lease Obligation | 12,000 |
Trade and other payables | - |
Short-term borrowings | 10,000 |
Current tax payable | - |
52,000 |
Tax obligations, and trade & other payables have been excluded from the calculation of debt as they constitute non-interest bearing liabilities.
| Working 2: Long-Term Debt | USD |
|---|---|
Non-Current portion of long-term loan | 15,000 |
Current portion of long-term loan | 15,000 |
Deferred Tax | - |
Finance Lease Obligation | 12,000 |
42,000 |
All current liabilities have been excluded from the calculation of debt other the $15000 which relates to the long-term loan classified under non-current liabilities.
Explanation
Debt-to-equity ratio quantifies the proportion of finance attributable to debt and equity.
A debt-to-equity ratio of 0.32 calculated using formula 1 in the example above means that the company uses debt-financing equal to 32% of the equity.
Debt-to-equity ratio of 0.25 calculated using formula 2 in the above example means that the company utilizes long-term debts equal to 25% of equity as a source of long-term finance.
Debt-to-equity ratio of 0.20 calculated using formula 3 in the above example means that the long-term debts represent 20% of the organization’s total long-term finances.
Each variant of the ratio provides similar insights regarding the financial risk of the company. As with other ratios, you must compare the same variant of the ratio to ensure consistency and comparability of the analysis.
Analysis & Interpretation
What is an acceptable debt-to-equity ratio?
Debt-to-equity ratio which is low, say 0.1, would suggest that the company is not fully utilizing the cheaper source of finance (i.e. debt) whereas a debt-to-equity ratio that is high, say 0.9, would indicate that the company is facing a very high financial risk.
Companies generally aim to maintain a debt-to-equity ratio between the two extremes. Obviously, it is not possible to suggest an ‘optimum’ debt-to-equity ratio that could apply to every organization. What constitutes an acceptable range of debt-to-equity ratio varies from organization to organization based on several factors as discussed below.
When debt-to-equity ratio falls outside an acceptable range, a corrective action may be required by companies (e.g. inject more equity), investors (e.g. disinvestment) or lenders (e.g. discontinue further lending).
| Factors that influence the level of debt-equity ratio | Explanation |
|---|---|
Degree of stability and predictability of business environment | Low debt-to-equity ratio suits companies operating under volatile and unpredictable business environments as they cannot afford financial commitments that they cannot meet in case of sudden downturns in economic activity. |
Availability of suitable assets for offering security to lenders | Availability of assets held for long-term use and not subject to drastic fluctuations in their valuation under normal conditions (e.g. buildings) increase an organization's apatite to sustain a higher debt-to-equity ratio because it offers better security to lenders in the event of a default. |
Interest Coverage | A healthy interest coverage ratio suggests that more borrowing can be obtained without taking excessive risk and vice-versa. |
Regulatory and contractual restrictions | Regulatory and contractual obligations must be kept in mind when considering to increase debt financing. |
Importance
Why should we measure debt-equity ratio?
Debt-to-equity ratio directly affects the financial risk of an organization.
Financial risk is simply the risk that a company defaults on the repayment of its liabilities. When debt-to-equity ratio is high, it increases the likelihood that the company defaults and is liquidated as a result. Obviously, this is not good for investors and lenders because it increases the risk associated with their investment or lending which causes them to require a higher rate of return to compensate for the additional risk. Increase in the required return of investors and lenders means an increase in the cost of capital to the company.
A higher debt-equity ratio however is not always a bad thing.This is because debt is a cheaper source of finance compared to equity because of tax savings (dividends are not tax deductable) and predictable return for lenders.Therefore, when the financial risk is at an acceptable level,increasing the debt-to-equity level could benefit the company through a reduction in the cost of capital. This is because when debt-to-equity level increases, the more expensive source of finance (i.e. equity) is replaced by the cheaper alternative (i.e. debt) leading to an increase in shareholder wealth. However,increasing the gearing level too highwould cancel any benefits associated with debt-financing because the increase in the required rate of return of investors and lenders because of the risk of bankruptcy would outweigh the tax savings as explained in the Trade-Off Theory of capital structure.
From the perspective of companies, it is therefore important to measure the debt-to-equity ratio because capital structure is one of the fundamental considerations in financial management.
From the perspective of investors and lenders, debt-equity ratio affects the security of their investment or loan. Measuring debt-to-equity ratio of companies provides them a measure of the financial risk associated with their investment or lending which influences their required rate of return and their decisions to investment or disinvest.
In order to reduce the risk of bad loans, banks impose restrictions on the maximum debt-to-equity ratio of borrowers as defined in the debt covenants in loan agreements.
Also, companies operating in the financial sector such as banks and insurance companies are often required to measure and maintain their debt-to-equity ratio below a certain level under various regulations (e.g. prudential regulations) designed to promote stable financial systems.
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