Importance and limitation of debt to equity ratio

Introduction:

Debt to equity ratio is computed by dividing the total liabilities of the company by shareholders’ equity. This ratio is represented in percentage and reflects the liquidity of the company i.e. how much of the debt owed by the company is used to finance the assets as compared to the equity.

The investors and especially the potential equity shareholders always use this ratio to assess company financing strategy since they are concerning about to profit that could deliver to them after paid to creditors, banks, as well as treasury shareholders.

Before moving to the discussion the limitation and advantages of debt to equity ratio, now let see the formula first,

The formula:

Debt to equity = Total liabilities / Total shareholders’ equity

A high debt/equity ratio is usually a red flag indicating that in the case of solvency the company will go bankrupt with not enough equity to cover the debts. A low debt/equity ratio indicates lower risk since the debt is lesser than the available equity.

A debt-to-equity ratio is an important part of ratio analysis performed under financial analysis. It is included under gearing ratios along with time interest earned ratio, debt ratio, and equity ratio.

Gearing ratios are a metric used to demonstrate the funding of an entity’s operations i.e. whether it was covered through debt or the investment made by shareholders.

An ideal debt/equity ratio is around 1:1 which means equity must be equal to liabilities; however, the optimal ratio depends more on the type of industry and may vary from industry to industry.

The following is the discussion of key importance and limitation of debt to equity ratio:

Importance of debt to equity ratio:

Debt to equity ratio is particularly significant for the financial analysis of a company. A list of points explaining the importance of the debt/equity ratio is mentioned below:

  • Debt to equity ratio is an important tool used in financial analysis to enable potential investors to examine the health of a company. A high debt to equity ratio is an indication of low liquidity. It means that the entity is unable to finance its obligations through the cash and reserves and is dependent on the creditors. The probabilities of the entity to go bankruptcy are high. It is a sign that new investors their money in.
  • Debt to equity ratio also helps in understanding shareholder’s earning. A high debt implies that high interests are paid by the company which reduces profits significantly. A decrease in profit is a decrease in dividends paid to the ordinary shareholders.
  • Debt to equity ratio is used by lenders and creditors as well when a small business applies for the loan. It signifies the entity’s credit trustworthiness and how regular they are in regards to payment of installments.
  • It is helpful for management to demonstrate the competition in the market. Debt to equity ratio can help the entity understand its performance against the competitors. This may help the management in making improvised decisions to reach the ideal debt/equity ratio.

Limitations of debt to equity ratio:

  • Debt/equity ratio may misguide the potential investors as well since a low debt to equity ratio can be a result of the company not appropriately financing the assets with the debt obtained. This is an indication of technical inefficiency which would result in lower returns even if the debt/equity ratio is low.
  • The optimal debt/equity ratio that is 1:1 can’t be widely used for all the industries out there. A capital-intensive entity may have a high debt/equity ratio indicating that net assets have been regularly maintained and financed through the debts obtained which would increase returns in the future due to higher production. However, a low-capital industry doesn’t need to invest in factories and types of equipment hence its optimal ratio should be around 1:1. This is one of the major limitations of the debt/equity ratio since it can only compare similar companies’ financial performance.
  • Debt to equity ratio requires context to understand. A person who isn’t well versed with accounting may not be able to defer the terminologies mentioned in the balance sheet. A clear understanding of the terms equity and liabilities is required to understand the concept and objective of the debt/equity ratio.

What is the formula that use for calculating debt to equity ratio?

Formula:

The formula that we could use to calculate debt to equity ratio is: Debt to equity ratio = Total Debt / Total Equity. Debt refer to kind of liabilities including short term and long term liabilities. For example, short term loan, account payable, noted payable, interest payable, and long term loan. We need to include them all. Total equity here include all kind of equity items that report in balance sheet. For example, ordinary share, preferred share, retain earning, accumulated others comprehensive income etc. For easy calculation, you can also use this equation, Assets = liabilities + Equity, to find equity balance.

Or

Here is detail of each items:

  • Total liabilities here include both current and non current liabilities that report in the balance sheet at the reporting date. They are including short term loan, long term loan, account payable, noted payable, tax liabilities, accrual expenses, salaries payable, unearned revenue, and others liabilities.
  • Total equity here included all kind of equity items that report the balance sheet on the same period of liabilities. These items including ordinary shares, preferred shares, retain earning, accumulated gain or loss, and others equity items.

Calculate debt to equity ratio:

Example, the following is the list of debt and equity that extract from entity financial statements at the end of 31 December 2016.

Here are debt:

  • Noted payable = 30,000
  • Account payable = 40,000
  • Short term debt = 100,000
  • Long term debt = 200,000

Here are the equity:

  • Ordinary share = 200,000
  • Preferred share = 100,000
  • Retain earning = 20,000

Now let calculate debt to equity ratio:

Debt to equity ratio = Total Debt / Total Equity = 370,000/ 320,000 =1.15 time or 115%

Based on calculation above, we noted that the entity’s debt to equity ratio is 115%. This ratio appear that the entity has high debt probably because of the entity financial strategy on obtaining the new source of fund is favorite to debt than equity. As we know, debt and equity are the two main method that the entity could use to obtain the new fund for new project. However, high debt might not good for the shareholders since the company has to pay for interest expenses first before paying shareholders. High debt might also not good for the entity since soon it will face financial difficulty.

Debt to equity ratio

Definition:

The debt to equity ratio is the debt ratio that use to measure the entity’s financial leverages by using the relationship between total liabilities and total equity at the balance sheet date.

Debt to equity ratio is normally used by bankers, creditors, shareholders, and investors for the purpose of providing the loan, extend credit terms, as well as an investment decision.

There is no specific rule to said that how much is the good debt to equity ratio and how much is bad. However, if the ratio is 100%, that means the entity could use all of its equity to pay off its debt.

Formula:

The debt to equity ratio can be calculated by dividing total debt by total equity at the end of the period. These total debt and total equity figures can take from the balance sheet.

  • Total liabilities here include both current and non-current liabilities that report in the balance sheet at the reporting date. They are including short term loan, long term loan, account payable, noted payable, tax liabilities, accrual expenses, salaries payable, unearned revenue, and other liabilities.
  • Total equity here included all kinds of equity items that report the balance sheet on the same period of liabilities. These items including ordinary shares, preferred shares, retain earning, accumulated gain or loss, and other equity items.

Example:

For example, ABC company has the following financial information as at 31 December 2016,

  • Short term loan = 100,000 USD
  • Long term loan = 40,000 USD
  • Account payable = 30,000 USD
  • Noted payable = 40,000 USD
  • Tax liabilities = 50,000 USD
  • Accrual expenses = 60,000 USD
  • Salaries payable = 30, 000 USD
  • Unearned revenue = 30,000 USD
  • Others liabilities = 50,000 USD
  • Equity = 500,000 USD

Calculate debt to equity ratio of ABC company.

Answer:

Based on the information above, we got

  • Total liabilities = 900,000 USD
  • Total equity = 500,000 USD

Analysis:

As mention above, the debt to equity ratio is used to assess the entity’s financial leverage as well as liquidity problems. This ratio is going up and down is depending on the entity’s financial strategy.

For example, the entity plan to increase its operations by increasing production line. This increasing require new sources of fund. In this case, the entity might raise the fund through a loan or equity.

High debt compare to equity will not only increase the ratio, soon the entity financial gearing will increase, and this might affect shareholders.

The effect to shareholders is through dividends since part of the entity earnings have to pay interest expenses.

There are many ways that we can use to improve this ratio. The first is to raise new funds from selling the new share. This will help the entity to have some funds to settle the debt which will subsequently improve the ratio.

How to calculate debt to income ratio?

Debt to income ratio is the importance ratio that help banker and analyst to assess whether the loan requester could be able to pay off the debt that they are requesting or not.

If the ratio too high, the bank might consider not to provide the loan.

And if the ratio is low, the process of requesting loan is highly likely to success. Now, to be able to calculate the debt to income ratio, we need to know two importance things.

First is the recurring monthly income, and second is the gross monthly income. These two importance things will be used to calculate DTI.

Formula:

You should be able to understand the formula of debt to income ratio before start calculation. Now here is the formula,

Debt to income ratio = monthly recurring debt / monthly gross income. 

  • Monthly recurring debt is any kind of debt the need to be paid monthly. For example, car loan, hours loan, and any others types of loan.
  • Monthly gross income is any kind of income that earn monthly. For example, salary income and any others kind of income that could be verified. This is very importance. You can not just include the figure in, but you should be able to provided the evident to confirm that those income is real.

Calculate debt to income ratio:

Calculate debt to income ratio is quite easy if you know all of the items mention above, and they are verifiable. Here is example,

Assuming you have the following monthly recurring debt:

  • Mortgage or rent = $1,000
  • Minimum credit card payments = $500
  • Car loan = $1,500
  • Student loans = $500
  • Alimony/child support payments = $1,500
  • Other loans = $2,000

Monthly gross income:

  • Salary = $3,000
  • Overtime = $500
  • Other income = $500

Answer:

  • Total monthly debt = $7,000
  • Total monthly gross income = $4,000

Debt to income ratio = $7,000 / $4,000 = 1.75 time or 175%

Based on calculation above, we got debt to income ratio 1.75 time or 175%. This ratio is quite high and it might not attract bank attention to provide the loan unless there is evident that the ratio could improve.

For example, part of the monthly debt will soon be paid off, and there will be new income line to improve cash flow.

Debt to income ratio: Definition, Formula, Example, and Analysis

Definition:

Debt to income ratio (DTI) is the debt ratio that used to assess the financial credibility and ability that entity or individual could pay off its debt by considering the relationship between recurring monthly debt over the gross monthly income.

Debt to income ratio is normally used by lenders, bankers, or creditors to assess prospective borrowers’ financial position who requesting a loan or some kind of credit.

Basically, if the ratio is equal to one, that means the prospective borrowers currently use all of their gross income to pay off the debt.

Formula:

The formula used to calculate the debt to income ratio is very simple and easy. There are two important things that you need to know. First is monthly debt that needs to pay off, and second is monthly gross income.

Here is the formula to calculate Debt to income ratio:

Debt to Income Ratio : Recurring Monthly Debt / Gross Monthly Income

  • Measurement: This ratio is measured as the percentage (%) or time
  • Recurring monthly debt: This is the monthly debt that needs to be paid. For example, monthly payment to the car loan, monthly payment to mortgages, and another similar kind of debt or expenses.
  • Gross monthly income: This is referred to as a total monthly income that earns. For example, monthly salary income, monthly sales income or similar kind.

Example:

Jame’s monthly payment to a loan for his new car amount 1,000 USD, installment for his new house 3,000 USD, and others debt amount 3,000 USD. Currently, Jame earns a monthly gross income amount of 8,000 USD. Calculate Jame’s DTI.

Answer:

Based on the example above, we got

  • Recurring monthly debt = 7,000USD (1,000USD + 3,000USD + 3,000USD)
  • Monthly gross income  = 8,000 USD ( provided)

Then,

Debt to income ratio = 7,000 / 8,000 = 0.875 or 88%

Analysis:

Debt to income ratio is one of the most important factors in the success of loan processing. If the ratio appears good, then the loan process is highly successful.

However, if you got the ratio around 48% or above, then the rate of success is quite impossible. In general, the lower the ratio you got, the better chance you have. The god ratio is below 20%, but the maximum ratio depending on creditor or bankers.

based on the calculation above, Jame got 88% of DTI and this rate is very difficult for him to get success on his loan processing. The bank might not allow him to get the loan. However, DTI is just the one factor to assess the possibility that Jame is able to pay back the loan to the bank.

If Jame could prove that his DTI ratio will very soon go better and he will be able to pay back all the debt as well and monthly payment, the bank might consider. For example, the pay for current monthly debt is going to pay off next month.

Let say, monthly payment for new car amount 1,000 USD, and installment for his new house 3,000 USD will end next month. That means the DTI will significantly decrease and the bank might consider the loan.

Debt to Equity Ratio: Formula | Definition | Using | Example | Analysis

Definition:

Debt to equity ratio is one of the liquidity ratios that use to assess the liquidity problems of an entity by using total debts to total equity at a period of time.

Debt to equity ratio concerns all types of debt, short-term and long-term debt over the total equity, including share capital, retain earning, and others.

For example, the entity is facing high potential contingent liabilities. Contingent Liabilities is a type of potential liabilities as of the result of current obligation and they are outside the balance sheet items.

Calculation of the Debt to Equity Ratio is solely dependent on the balance sheet items. Therefore, this ratio does not solely represent the current financial situation of the entity.

The above is its concept and next is the formula and example.

Now let move to the formula,

Formula:

Debt to Equity Ratio = Total Debt / Total Equity

  • Total Debt here includes all types of debt both short-term and long-term debt. Short-term is quite simple. They are Account Payable, Accrual, Current Tax Liabilities, and Others Short-term debt. Long-term debt includes long-term loans, deferred tax liabilities, preferred shares, and others long term debt.
  • Total Equity here refer to the items like ordinary share, paid-up share capital, share outstanding, and retain earning.

Example: 

Now let me move the example of how to calculate the Debt to Equity Ratio.

For example, at the end of 31 December 2016, ABC company, the company operating in manufacturing have the following financial information.

Extracted from ABC’s Financial Statements.

Total Debt = USD10,00,000

Total Equity = $9,000,000

Now, let calculate the debt ratio together.

As the formula, Debt to Equity Ratio = Total Debt / Total Equity

Therefore the answer is 10,000,000 / 9,000,000 = 1.11

Analysis:

This ratio also concerns the financial gearing of an entity. The ratio wants to assess how the total equity could settle total debts. There is no role to say about how much is the good ratio and how much is the alert situation.

, the entity is financially secure when the ratio is below one. Higher than one means that total debt at the end of the periods smaller than total equity at that time.

The higher equity note that the entity could possibly pay all kinds of debt, short-term and long-term debt by using its own equity. However, most of the time, liquidity does not look only this sides.

Debt to Equity Ratio is just one side of liquidity. Moreover, financially secure does not mean the entity does not have a liquidity problem.

Base on the calculation above, the ratio is higher than one. This means the company is financially not secure. This ratio is normally review and analyzed by the debtor and creditor.

Sometimes it is analyzed by the current customer as well as suppliers. The supplier is concern about how could the company pay its credit sales and customers are analyze because they want to know how long the company could run its operation.

One the ratio is over one, the financial controller needs to make sure that this ratio is going down so that the company is easy to obtain the loan or extend the credit term from its suppliers.