Hi, Else here.
And today we're going to talk about the debt to equity ratio.
This ratio is calculated as a business's total liabilities
divided by the total equity.
It is used to measure the relationship between what
has been contributed by the creditors in the form of debt
and what has been contributed by the shareholders
in the form of equity.
It measures of businesses financial leverage--
the extent to which debt is used either aggressively or not
to grow the business.
The debt to equity ratio gauges the degree
to which a business is taking on debt in order
to increase its value.
The increase in debt is used to increase
the projects the business is involved in
and therefore increased future revenues.
Increased debt is associated with increased risk.
What does the word risk actually mean?
Risk is connected to the fact that future events,
transactions, circumstances, and results just cannot be
predicted.
Risk means unpredictability.
In the case of debt levels, additional debt
is connected to financing costs, but also
to adding value through growth.
If the financing costs are greater
than the benefits received from increased growth,
overall shareholders' equity will
decrease because lower profits means lower retained earnings,
which means lower equity.
High debt to equity ratios and an increase in the ratio
is, or may be, seen as a negative for these reasons.
Having said that, not all high debt to equity ratios
are bad, which is why I said may be.
Everyone who reviews debt to equity ratios
needs to be careful and consider a few factors.
The first would be the industry you're looking at.
Debt to equity ratios differ between different industries.
For instance, industries that require
a high level of investment in property, plant, and equipment,
like mining or car manufacturing,
may have much higher debt to equity levels than, say,
a service company providing financial advice
to their clients.
Debt to equity ratios should be compared between businesses
within the same industry.
The second consideration would be what liabilities are
included in total liabilities.
This may differ considerably between different businesses.
Some use only debt that requires a cash outflow--
meaning they omit unearned revenue.
Some include only long term debt,
which means they exclude all short-term liabilities--
even that can be complicated since if long-term debt is
close to maturity, the business may exclude it since it can
be categorized as short term.
All of these factors complicate the comparison of the debt
to equity ratio.
It is therefore important to do the following--
determine how the ratio is calculated in the businesses
you are reviewing, compare ratios
only for businesses within the same industry.
And finally, compare the ratio to benchmarks
that are available for the industry the business is in.
That will provide additional information for your analysis.
Let's do an example to better demonstrate these concepts.
For these examples will assume that total liabilities
is the total of all current and non-current liabilities.
Here we have two businesses--
Greene Manufacturing and Bleaue Manufacturing.
Greene Manufacturing has total liabilities of 50,000
and total equity of 100,000.
Using these figures, we can calculate the debt
to equity ratio, which would be 0.5 times,
or 50%, which is 50,000 divided by 100,000.
What does this mean?
It means that for every $0.50 of debt,
the business has bucket of equity,
the business is equity financed, meaning that equity finances
most of the purchase of the assets.
Now lets look at Bleaue Manufacturing.
They have the same total equity of 100,000,
but they have liabilities of 200,000.
Their debt to equity ratio is two times,
or 200%, calculated as 200,000 divided by 100,000.
This means that for every $2 of debt, Bleaue has only $1
of equity.
They are mainly debt financed, meaning
that the debt has financed or purchased a larger
portion of their assets.
Since both businesses are in the same industry,
we can compare them and decide which one we want to invest in
or which we want to loan money to.
Let's look at it another way Greene's debt to equity ratio
is 0.5 times, or 50%.
We know their assets are equal to their liabilities
plus their equity, so assets must be $150,000.
If we take the liabilities and divide them
by the total assets, and then take the equity
and divide that by the total assets,
we learn that $1 of assets is funded 33.3% through debt
and 66.7% through equity.
Again, we see that this business is equity financed.
If we do the same for Bleaue Manufacturing,
we can see that two times, or the 200% debt to equity ratio,
can be analyzed in the same way.
Assets are 300,000, equal to $200,000 liabilities,
plus 100,000 equity.
If we divide total liabilities by the total assets,
and then we divide the total equity by the total assets,
we discover that every $1 of assets
is funded 66.7% by the debt and only 33.3 by equity,
showing that this company is heavily debt financed.
We can then compare these two companies
to see which is debt financed, obviously Bleaue, and which
is equity financed, Greene.
What does this mean?
It means that Bleaue manufacturing has higher risk.
A higher debt to equity ratio is considered riskier,
because it shows that the shareholders have not
funded a large portion of the business' operations.
This might be seen as a lack of performance
on the shareholders part.
It is riskier because debt requires
interest payments and expense, which reduces profit,
reduces retained earnings, and reduces equity in the end.
Finally, the principal must be repaid
at some point in the future--
a future where we don't know what
the economy or the business's financial position might be.
Both the interest and principal repayments
require an outflow of cash from operations,
reducing the cash available to either grow the business
or pay dividends to the shareholders.
In addition, if there is a downturn in the economy,
the cash flow from operations might be reduced
and this can seriously impact the ability of the business
to service and repay their debt.
You can see why the debt to equity ratio
measures of businesses leverage.
They are leveraging their present
in the hopes of an uncertain future.
Companies with high debt to equity ratios
may not be able to attract additional capital
from either creditors or potential investors.
Is a low debt to equity ratio better?
Certainly low debt to equity ratios
are preferred by the investors and lenders,
because they are better protected
in an economic downturn.
This is due to lower, ongoing interest
costs and lower requirements for principal repayments.
However, a low debt to equity ratio
may not be a good thing either.
Why?
Because it may indicate that the business is not
taking advantage of the growth and therefore
the increased future profit that taking on debt may bring.
Remember, taking on debt is used to increase the projects
the businesses involved in and therefore,
increase future revenues.
Just because there are negatives connected with the high debt
to equity ratio does not mean that a high debt
to equity ratio is bad.
As we noted before, we can't assess a debt to equity ratio
without careful consideration of a number of factors.
Remember to complete an appropriate analysis
and make a reasoned and well-supported conclusion.
Thank you for watching my video on the debt to equity ratio.
I hope you will join me again for future videos
about the ratios.