What is the Debt to Equity ratio?
One of the most widely used Solvency Ratio or Leverage Ratio is the Debt to Equity ratio or DE Ratio.
In evaluating stocks for investment, the Debt-Equity ratio is the most prominent financial ratio. It helps in understanding the likelihood of the stock to perform better relative to others.
The beauty of this ratio lies in its simplicity.
Debt Equity ratio is the ratio between the Total Debt of the company to the Total Equity.
It shows how much Debt does the company have relative to Equity.
Although the ratio appears to be simple, it provides greater insight into the company’s Capital structure and the company’s strategy to earn better ROE to the Equity Shareholders.
Let us look at the formula and a few examples to understand the ratio better.
Debt to Equity ratio Formula
The formula for the Debt-Equity ratio is as simple as it can be.
We take Total Debt in the numerator and Total Equity in the denominator.
Below are few important considerations for calculating the numerator and denominator
Total Debt
- Total Debt refers to the money borrowed by the company as part of its business operations.
- Although many analysts take Total Liabilities in the numerator, it is important to consider only those liabilities that are in the form of Debt.
- Below are the important items that are not considered as Debt.
- Accounts Payable
- Other Payables
- Accrued Expenses
- Similarly, below are the most items that are considered as Debt.
- Short term borrowings
- Long term borrowings
- Bonds Liability
- Short term Capital lease obligations
- Long term Capital lease obligations
Total Equity
As per IAS32, Equity is defined as “… A Residual interest in the Assets of an entity after deducting all of its liabilities.”
Simply said, it is the Capital given by the Equity Shareholders, the owners of the company.
General Equity Capital has various components that are reported on the Balance Sheet.
Below are the commonly found components of Equity.
- Common Stock
- Paid-up Capital
- Retained Earnings
- Other Equity
- Minority Interest
We need to include all such components while arriving at Total Equity.
Why the Ratio is important?
The DE ratio basically indicates how much Debt does the company has against Equity Capital. Below are few reasons why this ratio is more important.
- If a company has a high Debt relative to Equity, the Company will have to pay Interest on such Debt.
- Under such a situation, the high-Interest expense will eat away most of the operating profits.
- Lenders often track the DE ratio to determine the Debt paying ability of the company.
- If the ratio is relatively high, lenders demand high interest rates.
- Similar to lenders, even Investors often pay attention to this ratio.
- If the ratio is Increasing, Investors would be cautious and expect a higher return for the increased risk.
Let us quickly understand how to calculate the DE ratio using a small example.
Debt to Equity ratio Example
Let us consider the below-given companies Alpha Inc. and Beta Inc.
Below given is the Balance Sheet extract for the companies.
All the values are in $millions.
To calculate the ratio we need,
- Total Debt
- Total Equity
Both values can be obtained from the Balance Sheet.
Total Debt
In the given example, items like Accounts Payable, Accrued expenses, Other liabilities will not form part of Total Debt.
Total Debt = Short term Debt + Long term Debt
- Alpha Inc.= $30 + $150 = $180
- Beta Inc.= $20 + $100 = $120
Total Equity
As evident from the example above, company has 3 Equity components.
Total Equity = Common stock + Retained earnings + Other Equity
- Alpha Inc. =$100 + $20 + $80= $200
- Beta Inc.=$100 + $300 + $300= $700
Having found both the values, we can quickly find the DE ratio for both the companies.
Debt-Equity ratio = Total Debt/ Total Equity
- Alpha Inc.= $180 / $200 = 0.9 times
- Beta Inc.= $120 / $700 = 0.17 times
As evident from the calculation above, the DE ratio for Alpha Inc is 0.9 times while for Beta Inc. it is as low as 0.17 times.
What this indicates is that Alpha Inc. has relatively high Debt compared to Beta Inc.
Clearly, Aplha Inc, as part of its Capital Structure, has almost the same Debt and Equity. (Refer left pie on the chart above)
On the contrary, Beta Inc. has majority of its Capital in the form of Equity.
Hence, Beta Inc. is considered a less risky company.
Debt to Equity ratio Using Excel
In our next example, let us calculate the Debt-Equity ratio using Excel.
We have considered the Financial Statements of US-based retail company- Walmart.
You can download the template from the Marketplace.
Consider the below-given Consolidated Balance Sheet of Walmart.
To calculate the Debt-Equity ratio, we need
- Total Debt
- Total Equity
Let us find the values for and calculate the ratio.
Total Debt
In the case of Walmart, below are the items that form part of Debt.
- Short term Debt
- Current lease obligations
- Long term Debt
- Non current lease obligations
After adding all the above values, we get
Total Debt = $5,255 +$2,605 +$39,657 +$6,683 = $54,170
Total Equity
To calculate the Total Equity for Walmart, consider the below Equity Capital extract from the Balance Sheet.
Below are the items that form part of Equity Capital.
- Common Stock
- Additional PaidIn Capital
- Retained Earnings
- Other Equity
- Minority Interest
Adding all the components of Equity, we get
Total Equity = $79,634
Now that we know the numerator and denominator, let us quickly calculate the ratio.
Debt to Equity ratio = Total Debt/ Total Equity
= $54,170 /$ 79,634 = 0.68 times
As evident from the calculation above, the DE ratio of Walmart is 0.68 times.
What this indicates is that for each dollar of Equity, the company has Debt of $0.68.
Ideally, it is preferred to have a low DE ratio. But in the case of Walmart, it is 0.68 times.
To understand if the ratio is good or bad, we need to compare the ratio with that of other companies’.
Nonetheless, the ratio is less than 1 which appears to be healthy. But the conclusion should not be drawn merely on a single period ratio. You should also analyze how the ratio has changed over the period.
Debt to Equity ratio Interpretation
Let us look at how to interpret this ratio.
High Debt to Equity ratio
- High Debt-Equity ratio indicates the company has significantly higher Debt relative to Equity.
- Since the company has a relatively high Debt, the company will also have high interest burden.
- If the liquidity position of the company is bad, it may find it difficult to meet its interest payments.
- And if the situation worsens, it may even have to file for Bankruptcy.
- Since the Debt portion is relatively higher making the Equity Capital lower, it tends to increase the Return On Equity ratio.
- When the company has access to cheap Debt Capital, It raises additional Capital via Debt instead of Equity making the ratio higher.
- At times, company may not willing to dilute its Equity stake. Hence, it may be raising additional Capital via Debt making the DE ratio increase.
Low Debt to Equity ratio
- A low DE ratio indicates that the company has a relatively lower Debt then Equity.
- Having a low DE ratio will not put any pressure on profitability since the interest expense will be relatively low.
- This results in better Operating profits and Pretax Profits.
- Companies with a low DE ratio has relatively higher flexibility in terms of raising Debt.
- Also, having a low DE ratio allows the company to raise Debt capital at a competitive rate
Trend Analysis
To analyze the ratio better, we need to look at how the ratio has moved historically.
It helps in understanding if the ratio profile is sustainable in the future.
Let us look at how the Debt Equity ratio for Apple has evolved over the period.
As evident from the chart above, the DE ratio for Apple has been increasing for the past 5 years.
The company had a Debt-Equity ratio of 0.5 times back in 2015. But, subsequently, the company raised most of its additional Capital in the form of Debt. Hence, the ratio has been increasing significantly.
Currently, for the year ending 30th June 2019, Apple DE ratio is 1.2 times. This indicates that the company has almost $1.2 Debt on each dollar of Equity.
Although the ratio is more than 1, the company appears to be executing a strategy where it is relying on Debt Capital instead of Equity.
As already highlighted in Debt to Capital or Debt to Asset ratio resource, if the company is earning margins that are greater than the cost of Debt, then borrowing money is logical.
This is what appears to be happening in the case of Apple.
Comparison With Similar Companies
Apart from performing a Trend Analysis of ratios, let us look at how different is the ratio when compared to other companies.
Consider the below-given chart plotting the Debt-Equity ratio for prominent companies.
- Among all the companies, US automaker Tesla has the highest DE ratio.
- Walmart has a DE ratio of almost 0.6 times.
- Microsoft has a similar ratio of 0.7 times
- But as you look at Amazon, it is relatively higher. Amazon has a Debt-Equity ratio of 1.2 times.
- As already seen in the trend analysis, Apple Debt-Equity ratio is as high as 1.3 times.
- Lastly, when we analyze the DE ratio of Tesla, clearly it appears that most of the company’s capital is in the form of Debt. The Debt-Equity ratio for Tesla is almost 2.7 times
Conclusion
So that was everything we need to know about the Debt-Equity ratio as part of Solvency Ratios.
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