How much debt a business has on its balance sheet? This is an important consideration when it comes to assessing financial health of a firm. Leverage ratios disclose to what an extent debt is used in a firm’s capital structure. It is believed that the more debt a firm has in its capital structure, the riskier its stock becomes. The underlying reason for this is that debtors have a priority or first claim to a firm’s assets and if ever, the firm went bankrupt, debtor’s claims must be paid off before stockholders (who are party to business risk and owners of the firm).
D/E or debt/equity ratio is an indicator of the debt financing in a business as compared to stockholder equity (finance by its owners/shareholders).
The formula for Debt/Equity Ratio
Debt/Equity Ratio = (Short-Term Debt + Long-Term Debt) / Total Equity
A high debt/equity ratio is an indicator of high risk business and a low debt/equity ratio, if other factors are similar, is deemed to mean that the business is less riskier than those with higher debt/equity ratio. However, one should not jump to the conclusion that debt is an evil and a low debt/equity ratio is an indicator of splendid financial management. Low debt/equity ratio may also indicate that a business is not using financial leverage to enhance its profitability.
How? One is prompted to ask….
Very briefly, the cost of debt is ‘fixed’ while that of equity is not – shareholders have a claim on the profits through dividends. It is also important to note that ‘fixed’ doesn’t necessarily mean high cost and that is where financial leverage comes into play – by optimizing its capital structure on debt as well as equity, a business actually ends up paying out less as a composite of dividends and interest.
Another factor that is to be remembered is that comparison of debt/equity ratios should generally be done among businesses within the same industry as higher debt/equity ratios are generally observed in capital-intensive industries.
We’ll learn about Interest Coverage in the next post.