Leverage is a necessary yet risky aspect of corporate structure. For this reason, analysts and investors pay close to attention to a company’s debt to equity ratio. This reveals capital structure of the company and tells if the company operates at optimal levels.
What Is The Debt To Equity Ratio?
The debt to equity (D/E) ratio measures a company’s financial leverage. To calculate this ratio, one divides total liabilities (debt) by total stock holder’s equity.
D/E = total liabilities / stock holder’s equity
Additionally, the debt to equity ratio shows how much debt a company takes on relative to the value of its stock. Higher D/E ratios imply riskier financing tactics by the company. Also, higher levels of debt often lead to erratic earnings pattern given the interest expenses on the debt.
The Debt To Equity Ratio In Practice
Some consider the use of leverage risky, which leaves some companies with only equity financing. However, using debt often creates shareholder value, which is management’s foremost goal. If the company generates more profit than it would have without the debt, and the earnings outweigh interest expenses, shareholders benefit. Conversely, too much debt or too high of interest payments destroys value and decreases company earnings.
Furthermore, if a debt-laden company files for bankruptcy, equity shareholders potentially receive nothing. In bankruptcy, owners of debt recoup losses first.
Also, the debt to equity ratio alone misguides analysts. Analysts must compare it against a benchmark, such as an industry average. This means that tech heavy companies have a much different D/E ratio than a utility company. Comparing them side by side does not make sense.
Finally, debt to equity ratios are integral in financial analysis. Companies without debt may be leaving potential earnings on the table, while overbearing debt cripples other companies and forces bankruptcy. Comparing D/E ratios within industry reveals valuable insights and shows investors if the company maximizes its earnings potential.