Debt-to-Equity Ratio


Definition

Debt-to-Equity Ratio, often referred to as Gearing Ratio, is the proportion of debt financing in an organization relative to its equity.

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 the book or market value of interest-bearing financial liabilities such 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 2014
2014
USD
ASSETS
Non-current assets
Property, plant & equipment130,000
Goodwill30,000
Intangible assets60,000
220,000
Current assets
Inventories12,000
Trade receivables25,000
Cash and cash equivalents8,000
45,000
TOTAL ASSETS265,000
EQUITY AND LIABILITIES
Equity
Share capital100,000
Retained earnings50,000
Revaluation reserve15,000
Total equity165,000
Non-current liabilities
Long term Loan15,000
Deferred tax8,000
Finance Lease Obligation12,000
Current liabilities
Trade and other payables35,000
Short-term borrowings10,000
Current portion of long-term borrowings15,000
Current tax payable5,000
Total current liabilities65,000
Total liabilities100,000
TATAL EQUITY AND LIABILITIES265,000

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

Non-Current portion of long-term loan15,000
Current portion of long-term loan15,000
Deferred Tax-
Finance Lease Obligation12,000
Trade and other payables-
Short-term borrowings10,000
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

Non-Current portion of long-term loan15,000
Current portion of long-term loan15,000
Deferred Tax-
Finance Lease Obligation12,000
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 ratioExplanation
Degree of stability and predictability of business environmentLow 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 lendersAvailability 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.

Conversely, where most assets are held in the short term (e.g. inventory) or are prone to subjective valuations (e.g. intangible assets), the organization's apatite to sustain a high debt-to-equity ratio is reduced because such assets offer lesser degree of security to lenders in the event of a default.
Interest CoverageA healthy interest coverage ratio suggests that more borrowing can be obtained without taking excessive risk and vice-versa.
Regulatory and contractual restrictionsRegulatory 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 high would 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.