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Debt to equity ratio is one of the major financial metrics that investors look at.
It shows how much leverage or borrowed money the company is using to increase potential returns. It displays the capital structure of the company, whether it’s oriented more toward debt or equity financing.
Debt to equity ratio is calculated by dividing the total debt of the company (short-term debt, long-term debt & fixed payment obligations) by the shareholders equity, which is the money that shareholders injected into the company. Both information can be extracted from the company’s reported Balance Sheet.
Debt-to-equity = total debt / shareholders equity
The importance of debt to equity ratio
Debt is not always bad. If it is used to fund a high Return of Equity (ROE) project, then it may be a cheap source of funds particularly given the fact that interest expense is tax deductible. Yet, if debt is a reflection of persistently negative Cash Flow from Operations (CFO), then the firm may be relying on a life line to remain alive and this may increase the risk of financial distress.
Companies with higher debt to equity ratio tend to have a high leverage, which means that they are able to launch projects they couldn’t build without this financing. This type of financing positively affects the company’s future income.
The cost of debt is typically lower than the cost of equity. This is due to the fact that risk to shareholders is greater than to lenders since payment on a debt is required by law regardless of a company’s profit margins.
Downside of a high debt-to-equity ratio
The downside of having a high leverage is that it can be risky for companies that are not yet stable in terms of generating positive cash flows. Having a high debt in such companies can significantly increase the probability of bankruptcy, which generates 0% returns for the shareholders.
Typically, a ratio that ranges from 1-2x equity is acceptable. Higher ratios – without a strong justification – should make you alert.