DEBT TO EQUITY RATIO (D/E): Meaning and Shortcomings

 

D/E = Business liabilities / Shareholders equity.

 

The debt-to-equity ratio (D/E) is a metric that evaluates the extent to which a business is capable of funding its operation using debt or business-owned funds. In the case of a business downturn, the debt-to-equity ratio would be applied to see if the equity of shareholders of the company can be enough to balance all debts that are outstanding. Sometimes, accounts that are contained in a primary balance sheet often lack clarity. As a result, an investor usually tries to modify the debt-to-equity ratio and then use it to carry out a comparative analysis of different securities, including stocks.

There are several software with templates and worksheets that can be used to calculate the debt-to-equity ratio, the Microsoft Excel is one of such software. There are enough guides on how to use the Microsoft Excel software to calculate the debt-to-equity ratio, and even investors who are novice will be able to use this method to calculate the D/E ratio of their chosen company.

Now, we know that the debt-to-equity ratio of a company assesses the extent of how a business is able to fund its operation and also see how investors' equities can be used to offset debts in the event of a downturn. It is also necessary to note that if the debt-to-equity ratio of a business is high, then the business is already at great risk because the business' growth has been dependent on debt and credits.

Several studies have shown that the greater the debt used to sustain the operation of a business venture, the greater the earnings that the business venture is likely to generate compared to a situation where it has no other means of financing (in the form of loans). Shareholders of such businesses also have a great chance of making meaningful earnings provided that this leverage increases the net income of the business, more than the interest incurred from debts. Conversely, when the debt-to-equity ratio of a business exceeds the net income, shares of the company declines, lose value and then subsequently lose investors.

The debt-to-equity ratio can also be used by small businesses or individuals, when a loan is being applied for. The values of the debt-to-equity ratio will be used by the creditors (loan lenders) to evaluate if a borrower will be capable of repaying his or her loan. The use of the D/E ratio by small businesses and individuals is collectively termed "D/E ratio for personal finances."

 

Shortcomings of the debt-to-equity ratio

 

•    The debt-to-equity ratio varies with companies because some businesses are capital intensive than others. Capital intensive businesses often require loans for financing, which may result in a high debt-to-equity ratio.

 

•    When the D/E ratio is used to assess utility stocks, the values are usually high, which can often lead to a slow growth rate of industries.

 

•    Including certain stocks in total debts are capable of increasing the D/E ratio, making the company appear risky and making the shares non-palatable to investors.