What is the Debt to Equity Ratio?
Debt to Equity Ratio is a debt ratio which measures a company’s economic leverage or how much of the company if financed by debt and how much by equity.
The D/E ratio can be derived by dividing a company’s liabilities on the whole by its stockholders’ equity.
This ratio can be applied to personal financial statements as well as corporate ones.
Importance to A Company
The D/E ratio will show the extent to which a company is taking on debts in an attempt to increase its value by using debt money to fund itself.
If a company has a high value for D/E ratio, then it has probably been aggressive in using debt money for financing growth. This frequently leads to high risk and volatile earnings.
Debt financing potentially increases growth and thus earnings, but the additional expense on interest payments is the reason that debt financing is associated with volatile earnings and the need for enough liquidity to be able to pay off debts that come due might lead to high risk.
If the company does not have sufficient liquidity, even a successful company can fail.
Importance to Traders
High debt financing might lead to higher earnings if earnings increase more than the cost of debt. However, if debt cost is too high, then shareholders will suffer as benefits will be outweighed by the cost of debt.
For example: with debt financing, it is possible for companies to invest high amounts in new lucrative projects which might not be possible if they had to invest the company’s money only. But if interest payments are so high that the earnings on the new project are all used up in the interest payment, then obviously the shareholders will not see an increase in their bottom-line.
So they will face an increase in risk without an increase in return.
Given taxes and other regulations, the value of equity will be affected by the D/E ratio. A lot of the time, debt payments to banks will have tax breaks, so the cost of debt financing is offset by tax breaks.
So equivalent equity financing where the company pays full tax is actually more costly to the company. Thus it is something that traders must take into account.