Understanding the Debt to Equity Ratio: Debt to equity ratio (D/E) is a financial tool which is used for the assessment of leverage ratio or solvency ratio and tells about the soundness of a firm. The formula of the debt-to-equity ratio is debt divided by the shareholder’s equity. It takes into consideration of the total debt, comprising of an aggregate of short-term debt, long-term debt, and other fixed payment obligations (such as a capital lease) of a business that are incurred during the normal operations. Debt to equity ratio also reflects the company’s capital structure, whether the company goes for debt financing or equity financing. While considering the debt, the investor should not take into consideration all current and non-current liabilities. There are some items that are not included while calculating debt, that includes Accounts payable, Accrued expenses, Deferred revenues, and Dividends payable. Moreover, a high D/E ratio indicates that the firm is very aggressive in its expansion plan financing it through debt. If the company reinvests the debt in the business for the generation of more earnings, and if the earnings grow by a greater amount than interest costs, then the value of the company will increase, and the shareholders will benefit from it. On the other hand, if the cost of debt financing is more than earnings over the long run, then shareholders’ investment into the company will erode. This could eventually lead to a company’s bankruptcy, especially when the business conditions have a slowdown, then the company’s cash reserves will fall to low levels, and its debt cannot be paid off. Therefore, the companies that have a high debt-to-equity ratio of more than 40 to 50 percent should be analyzed and monitored, to ensure that the company is not facing any liquidity issues. If the company has sufficient cash flow, growth prospects and retained profits to meet its debt commitments, then the company is growing. On the other hand, if the debt to equity ratio is lower than peer, then it means that the company faces less financial risk and resultantly would command a higher value in term of the price multiple.
Applications for the industry: Each sector or industry has a different debt to equity ratio. For some industries, the amount of debt financing is required more compared to other industries. For capital intensive ones such as mining, debt-to-equity ratios are often higher, even if the company is viable and able to repay its debts. Further, the evolving industries or new companies that have not much track record should carry less debt. These companies’ business models are not fully tested, and their survival is always a question as there reliability of their future revenue stream is often difficult to judge.
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