Is Debt to Equity Ratio Really Gives a Fair Assessment to Business Sustainability

Debt to equity = Total liabilities ÷ Total shareholder’s equity

Debt to equity ratio focuses on the capability of a companyto meet its both short-term and long-term liabilities in relation to itsequity. Debt/Equity ratio can be calculated by dividing total liabilities withequity. Basically, the D/E ratio is a financial leverage ratio to measure thestability of a company.

The values in the formula are easily accessible from thebalance sheet of a company. Sometimes name may be changed as debt may bereported as total liabilities while equity may be listed as shareholdersequity.

Debt to equity ratio vs. gearing ratio

Leverage ratios flock contains a number of financial ratiosand debt to equity are one of these ratios. These ratios are designed specificallyto keep an eye on gearing or financial leverage. Typically the generalunderstanding about leverage says that slight leverage is good for a companybut too much of it shade off risks to the company.

Gearing refers to a relative measure between debt and equity where it keeps an eye on the % of funding as debt. While on the other side leverage refers to measure the % of debt utilized to invest in projects to get higher returns. This is where the gearing differs from leverage and it is the same difference one can find between debt ratio and debt-to-equity ratio.

Debt to Equity Ratio

How the debt to equity ratio is useful for investors

A higher debt/equity ratio indicates a higher risk, and itexplains that the company is aggressively investing its debt to achievefinancial growth. In other words, D/E ratio measures the extent to which acompany is using its debt to leverage its assets in term of profitability.

If a company is using debt to generate profits or earningsthen there are two things to look upon. One if the earnings are enough to meetthe finance cost (i.e. interest) or whether shareholders should expect to getbenefit from this investment. The share value can decline if thecost-to-benefit ratio declines as it is clear that the cost of debt is greaterthan earnings from the investment.

Both short-term and long-term debt & asset analysisrequire a different level of workings. Long-term debt & assets have a greatpotential to influence and manipulate the D/E ratio as both are large accountby nature. To analyze the ability of a company to meet its short-termliabilities, one may use ratios which measure short-term liquidity like currentratio or cash ratio.

Debt to equity ratio example

Ningx Co. publishes its financial statements for the fiscalyear 2018; it shows total liabilities of $11.3 million and shareholder equityof 5.83 million. The debt/equity ratio is equal to 1.21 for the fiscal year2018. CEO at Ningx Co. wants to compare the D/E ratio of his company to a rivalentity which has a debt/equity ratio for 2018 at 1.78 points. Calculate theNingx debt/equity ratio and then analyze the situation with your findings thensuggest your opinion.

D/E ratio = 11.3 ÷5.83

= 1.94

 It is now clear thatNingx Co. exhibits a slightly higher leverage ratio which suggests a higherrisk in comparison with its rival company. However, on the basis of informationprovided it would be too early to give any verdict and further inquiry is mustto look into both controllable and uncontrollable risks.

A thorough investigation is required to reach a finaldecision and discover what the obstacles are and what the possible things areto inflate the D/E ratio for both companies.