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Debt to Equity Ratio

What is the debt to equity ratio and does it apply to all business? The short answer is that investors and creditors use it to see if a business is likely to pay back its debt and sustain a decline in sales. This applies to most business, but it is not relevant to companies that don’t have debt. These two issues determine if the company is vulnerable to changes in the business cycle. If it is highly leveraged – meaning a high proportion of debt financing – it is riskier.

Reasons for the Debt to Equity Ratio

One reason that investors look at this leverage ratio is to judge whether the company will always be able to service its loans. If your ability to continually pay off debt is questionable, this highly geared (highly leveraged) business is not worth the risk. High debt payments can absorb any free cash flow in a business and lead it to a halt.

Debt to Equity Formula

The debt to equity formula is total liabilities/equity. This is the simplest version of the equation and considers both long and short term debt. Other versions of the debt to equity formula are adjusted to show long term debt/equity. This can be useful for certain industries but you should also compare it to the original formula (total liabilities/equity).

One thing about the debt to equity formula is that it is only one ratio. It does not give an in-depth view of the company’s debts but simply makes it easy to tell if something is noticeably off. Companies can also distort this ratio in an attempt to make another ratio look better. One example of this is with return on equity. If a business wants to keep a very high return on equity, it will only accept a certain amount of equity. The rest of the required financing will be from debt, thus optimizing the effect of the equity investment.

How do you use the debt to equity formula in your business? For further reading about debt to equity ratios, check out this article.

If you want to add more value to your organization, then click here to download the Know Your Economics Worksheet.

Debt to Equity Ratio, Debt to Equity Formula

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Debt to Equity

See Also:
Debt to Equity Ratio
Return on Equity Analysis

Debt to Equity Ratio

The debt to equity ratio is also known as the net gearing ratio. It is a type of leverage ratio that helps show how leveraged a company is. Investors and creditors often use this. The purpose is to see what ratio of equity and debt are used to fund the business. The more debt used increases the debt to equity ratio, thus signifying a highly leveraged business. Lenders see highly leveraged organizations as risky. Because if there are other debt obligations, the company is less likely to repay the lender. Investors understand highly geared (highly leveraged) companies to be more vulnerable to a slow in sales. If sales decrease, the debt service payments could be too high to pay off.

A highly leveraged company can be a riskier investment, because it will always have to service its debt. A low leveraged business uses more of the owner’s or business’s investment than outside investment. This avoids high debt payments that could halt a company’s cash flow during a downturn in sales. A highly geared business may be riskier, but it will also have more capital to expand and be profitable.


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Debt to Equity Formula

The debt to equity formula or equation is (debt/equity.) Many different sources use their own version of the ratio, but debt/equity is the simplest form. Some people prefer to use long term debt in the numerator in order to get a better idea of the risk of long term debt repayment. Whereas, others think this is a skewed view since it does not take short term debt into consideration. It varies by what types of debt the business has and what the investor is looking for.

Looking at the debt to equity formula does not tell the whole story. When considering businesses in different industries, it is important to decide which formula to use. Some industries are at a greater risk of long term debt or short term debt. When comparing these leverage ratios, it is a good idea to compute the basic debt/equity formula as well.

Industry Average Ratios

The internet, trade associations, and research firms have plentiful information on leverage ratios across different industries. This makes it possible to compare one business’s debt to equity ratio against others of similar size. University libraries usually have numerous subscriptions that give this information. They have comparisons across numerous different ratios, sizes, and industries. Interns from these universities have full access to these databases. Another option to gain access to these databases is by paying for access. It is often expensive and risky whether one service will be able to provide each statistic needed. This is why large corporations and universities subscribe to numerous services for the same information.

If you want to add more value to your organization, then click here to download the Know Your Economics Worksheet.

Debt to Equity

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Financial Ratios

See also:
Quick Ratio Analysis
Price to Book Value Analysis
Price Earnings Growth Ratio Analysis
Time Interest Earned Ratio Analysis

Use of Financial Ratios

Financial Ratios are used to measure financial performance against standards. Analysts compare financial ratios to industry averages (benchmarking), industry standards or rules of thumbs and against internal trends (trends analysis). The most useful comparison when performing financial ratio analysis is trend analysis. Financial ratios are derived from the three financial statements; Balance Sheet, Income Statement and Statement of Cash Flows.

Financial ratios are used in Flash Reports to measure and improve the financial performance of a company on a weekly basis.

Financial Ratio Categories

The following five (5) major financial ratio categories are included in this list.

  • Liquidity Ratios
  • Activity Ratios
  • Debt Ratios
  • Profitability Ratios
  • Market Ratios

Liquidity Ratios

Liquidity ratios measure whether there will be enough cash to pay vendors and creditors of the company. Some examples of liquidity ratios include the following:

Activity Ratios

Activity ratios measure how long it will take the company to turn assets into cash. Some examples of activity ratios include the following:

Debt Ratios

Debt ratios measure the ability of the company to pay its’ long term debt. Some examples of debt ratios include the following:

Profitability Ratios

The profitability ratios measure the profitability and efficiency in how the company deploys assets to generate a profit. Some examples of profitability ratios include the following:

Market Ratios

The market ratios measure the comparative value of the company in the marketplace. Some examples of market ratios include the following:

If you want to check whether your unit economics are sound, then download your free guide here.

Financial Ratios, Financial Ratio Categories, Use of Financial Ratios

Financial Ratios, Financial Ratio Categories, Use of Financial Ratios

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Debt to Equity Ratio

See Also:
Financial Ratios
Debt Ratio
Debt Service Coverage Ratio (DSCR)
Free Cash Flow

Debt to Equity Ratio Definition

The debt to equity ratio definition is an indication of management’s reliance to finance its asset on debt rather than on equity. It measures a company’s capacity to repay its creditors. This ratio varies with different industry and company. Comparing the ratio with industry peers is a better benchmark.

Debt to Equity Ratio Meaning

The debt ratio means an indication of the gearing level of a company. A high ratio means that a company may be over-leveraged with debt. This can result in high insolvent risk since excessive debt can lead to a heavy debt repayment burden. However, when a company chooses to rely largely on equity, they may lose the tax reduction benefit of interest payments. In a word, a company must consider both risk and tax issues to get an optimal debt to equity ratio explanation that suits their needs.


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Debt to Equity Ratio Formula

Use the following debt to equity ratio formula:

Debt to equity = total debt / total equity

Calculation of Debt to Equity Ratio

Debt to equity ratio calculations are a matter of simple arithmetic once the proper information is complied. Debts will include both current liabilities and long term liabilities.

Equity will include goods and property your business owns, plus any claims it has against other entities.

For example, a company has $10,000 in total debt, and $40,000 in total shareholders equity.

Debt to equity = 10,000 / 40,000 = 0.25

This means that a company has $0.25 in debt for every dollar of shareholders’ equity.

Debt to Equity Ratio Example

For example, Shari has started a residential real estate company which has grown to success. Though the market is tough, Shari has protected her cash account in order to deal with what the future holds. Shari now needs to perform debt to equity analysis to make sure she has not become over-leveraged in her company. This could cause problems with bank loans, her company free cash flow, and more.

Shari contacts her controller for debt to equity accounting questions. She knows that there is no debt to equity calculator, so she is willing to wait for some concrete results.

$10,000 in total debt and $40,000 in total shareholders equity.

Debt to equity = $10,000 / $40,000 = $0.25

Her controller finds that she is in perfect standing. Her company, though near its limit, does not have too much debt. It has enough cash to survive common issues which face the residential real estate industry.

She is satisfied that she has followed the path of a responsible business owner. Because she is so used to putting out fires, she is content with the status quo of her company’s regular monthly profits. Shari looks forward to her next quarter.

Resources

For statistical information about industry financial ratios, please click the following website: www.bizstats.comand www.valueline.com.

If you want to add more value to your organization, then click here to download the Know Your Economics Worksheet.

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Covenant Definition

See Also:
Company Valuation
Coupon Rate Bond
Fixed Income Securities
How to Manage Your Banking Relationship
Long Term Debt
Non-Investment Grade Bonds
Par Value of a Bond

Covenant Definition

The covenant definition is a restrictive clause in a bond contract. The purpose of the clause is to protect the lender (the party that invests in the bond) by imposing restrictions on the borrower (the party that issues the bond). Furthermore, the covenant amounts to the lender agreeing to lend money to the borrower as long as certain financial performance criteria are met and maintained throughout the duration of the loan contract.

Convenant Criteria

Covenants may cover criteria including the following:

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Financial Jargon

See Also:
Categories of Banks
Finding the Right Lender
Funding Source Versus Lender
How to Manage Your Banking Relationship
Interest Rate
Is it Time to Find a New Bank?

Financial Jargon

My client, Elliott, met a friendly banker at a networking function. The banker told him, “I like your business and would like to loan you and your company money”. Elliott spent time with him because he believed if he got to know him it would be easier to borrow money. But, when the time came for Elliott to borrow the money, the answer he got was no.

Elliott called to tell me he did not get the money and was upset because he thought the banker was his friend. My answer to Elliott was, “he probably is your friend. But, you are not getting what you want from the banker (money) because you are not communicating in his language.”

Elliott got mad during our conversation and said things like banks don’t loan you money unless you really don’t need the money. Then to make matters worse, I told him you, are probably right. He thought just because the banker was his friend and friends help friends in time of need, the money would be his for the having. After we talked a while and he settled down, I told him the problem. Bankers are the individuals who have invaded earth from another planet. They come from the planet known as Financial World. They look and act exactly like the rest of us that inhabit earth with one exception, their language. The language they speak is known as Financial Jargon.

Financial jargon or the language of accounting can make it difficult for the CFO and CEO to work seamlessly together to move the company forward. Learn the language of business in our CFO coaching workshop – the Financial Leadership Workshop.

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What is this Language of Financial Jargon?

Elliott asked, “What is this language of Financial Jargon?” I told him financial jargon is English or any other language spoken on planet earth but the majority of the human race does not understand the meaning of the words bankers speak. He asked, “Are you talking about financial ratios?” I told him yes, and gave him examples such as current ratioreceivables turnover, net working capital, gross margin, debt coverage, and debt to equity, which are just some of the terms in the language of Financial Jargon.

Sure, Elliott owns a business and survived college where he had taken a finance or accounting course. He even told me he had to memorize all the formulas to earn the grade he received. However, he went on to say, nobody told me I needed to understand the true meaning of these ratios to communicate with an alien known as a Bankers.

Ratios Hold Different Meanings for Bankers

Well, I told him these ratios do have different meanings to your banker than you were taught. Not enough time to teach him the entire language so I just explained one. I said debt to equity ratio could be defined as total debt to shareholders net worth. In college, you were taught this shows how leveraged a company is, in that the lower the ratio, the stronger the company.

To your banker, this ratio tells him who really owns your company; you or your creditors. Bottom line, if this ratio is high, your banker feels they are not talking to the owner of the company and will not loan you any money. So, Elliott, before you try to borrow money again, let’s make sure you are presenting your case in banker’s language.

Instead of using financial jargon around the executive team that doesn’t understand that language, break it down for them. Learn how you can be the best wingman with our free How to be a Wingman guide!

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Operating Leases Going Away?

The FASB (Financial Accounting Standards Board) and the IASB (International Accounting Standards Board) are recommending that the use of operating leases be scrapped. In addition, they are recommending that you treat all leases as capital leases. For over 40 years, FAS 13 has been the standard. But this step will change all that.

Operating Leases Going Away?

Under the proposed rules operating leases will be capitalized with both an asset and a liability account. Rent expense would go away and depreciation and interest expense would take it’s place.

Why is this important to a CFO? It’s the financial ratios! EBITDA no longer becomes useful in valuing a company. Your debt to equity ratio becomes inflated and the debt service coverage ratio becomes compressed. You will have to modify all your bank covenants to reflect the new presentation.

The question is: does this increased complexity add value to the process of evaluating the financial performance of a company? We will have to wait and see. Until July 2010 the accounting regulators are soliciting comments to their proposed changes. Implementation would not begin until 2011.

If you want more tips on how to improve cash flow, then click here to access our 25 Ways to Improve Cash Flow whitepaper.

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