The 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 concerned about the profit that could deliver to them after being paid to creditors, banks, and treasury shareholders.
Before moving to the discussion of the limitation and advantages of debt to equity ratio, now let see the formula first,
Debt to equity = Total liabilities / Total shareholders’ equity
A high debt/equity ratio is usually a red flag indicating that the company will go bankrupt with not enough equity to cover the debts in the case of solvency. A low debt/equity ratio indicates lower risk since the debt is lesser than the available equity.
A debt-to-equity ratio is an essential part of ratio analysis performed under financial analysis. It includes under gearing ratios and 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 the critical importance and limitation of debt to equity ratio:
Importance of debt to equity ratio:
The 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.