Debt to Equity Ratio by Industry

Raising capital is an inevitable step in growing your business to its next level. This is because as a company starts scaling, the need for funding also grows because there are employees to be paid and operational activities to be updated. It is also important to understand how to balance these costs on your company’s financial documents. And that requires you to be aware of certain financial terms, how they work and their formulas. One such crucial term is the Debt to equity ratio. It reveals the financial condition of your company and is a significant tool that investors use to gauge business performance. 

This article will help you understand the different types of debt in debt to equity ratio, how to calculate it using the debt to equity ratio formula and its analysis by industry.

Debt to Equity Ratio

A company’s financial statement should reveal the funds or capital borrowed from a financial institution called the debt. Also, the number of stocks or shares offered to investors denoting ownership allowance will also be mentioned in the sheet, which is called equity. Understanding the relationship between the two is key to maintaining the financial health of the organization. 

What is Debt to Equity Ratio?

Debt to equity ratio is a value that helps businesses determine how much of the company’s debt and equity is used to finance its operations. The company’s balance sheet will reveal the value of liabilities and equity assets in it. These two values are used to calculate the D/E ratio. These ratios vary with respect to the industry as the debt requirement is not uniform across these businesses. It is estimated that the collective ratio of the US amounts to 83.3% in Q2 of 2022, according to a Statista report. It is an indication of a healthy debt-to-equity ratio balance.

The higher the value of the Debt to equity ratio of a company, the investment risk is higher. It shows that the company is highly dependent on debt financing for its operations. It may look like the income generated is increasing in a debt-financed company. However, when the debt financing value overtakes the income, the value of shares is likely to come down. Depending on the market conditions, the revenue records may seem unprofitable over time. So it is important to understand the impact of debt financing with respect to current market conditions when securing funds.

Debt to Equity Ratio – Types of Debt

The types of debt in debt to equity ratio may vary according to industries, capital requirements and company potential. Some of the most common types of debt are listed below.

• Short-term Liabilities – The funds borrowed from a lender, bank or any financial institution for a short period are called short-term Liabilities. The stipulated time to repay is usually less.
• Long-term Liabilities – These debts are borrowed to serve a longer period. When companies borrow funds to support construction or manufacturing, it is usually long-term.
• Accounts Payable – When companies use their credits to purchase goods and services from their suppliers and repay them within a year or a stipulated payment cycle, an AP is claimed. 
• Accrued expenses – Some company expenses are incurred without an invoice or record but are marked on the balance sheet. They will also have a 12-month cycle to repay the amount.

Drawback of Debt to Equity Ratio

Although D/E ratio values help companies understand their position in terms of financial stability. But there are a few limitations in how these values can be perceived. Debt to equity ratios is industry specific. An ideal D/E value for businesses is expected to be 1 or less. But for companies with high capital requirements, it will naturally tend to be higher. Therefore bigger companies with a D/E ratio value even above 2 are acceptable. Also, there is an inconsistency in the definition of debts. For instance, preferred shares can potentially increase the D/E ratio value whereas they are not considered debts. 

Pros and Cons of High Debt to Equity Ratio

If the D/E ratio is high, it means that the business borrows funds from external resources to fund its operations. It is an indication to the investors that the company’s debts are already higher than their returns. But it is also important to compare the current ratio with the previous financial years. An increase in the debt to equity ratio may also mean the company is receiving intensive funds to improve its operation in the future. Here are a few pros and cons of debt to income ratio when the value is high.

Pros of High Debt to Equity Ratio

• When a D/E ratio value is high, it means the firm has the capacity to solve its debt commitments through its returns
• A high debt to equity ratio can bring down the company’s WACC ( Weighted Average Cost of Capital). It is the capital that the company has to pay to fund its assets.
• Having many sources to finance can help a company potentially increase its ROE (Return On Equity).

Cons of High Debt to Equity Ratio

• High debt to equity ratio can make the company have a hard time repaying the debts, in cases of losses or failure.
• The D/E ratio is linked to the equity cost. When the former increases, the latter also grows in value. When the cost of equity rises, the WACC value may suddenly increase thus bringing down the value of the share price.
• When the D/E value of a company is high it can make investors hesitate to commit to financial relationships with the company in the future.

Debt to Equity Ratio Formula

To calculate the D/E ratio, you must know the values of two elements – total liabilities and shareholders’ equity. The former is the collective value of the company’s debt and the latter is mentioned in the balance sheet. The following debt to equity ratio formula is used to calculate the value. 

In other cases, if you want to understand the company’s ability to repay short-term debts, you can find the cash ratio by using the following formula,

This can also be understood by using a similar formula,

These short-term liabilities are nothing but the payable amounts borrowed for a short while like employee wages and suppliers’ costs. They are also considered less risky.

Debt to Equity Ratio Calculation

After you apply the above formulas to determine the debt to equity ratio value, you need to understand if the outcome is positive or negative. A positive D/E ratio is when the utmost value of the ratio does not exceed 1 or 1.5. For industries that require bigger capital, the average ratio value can be 2 or 2.5. This scenario indicates that the company does not depend on funds to support its operations.

On the other hand, when the value exceeds 2.5, it is considered negative. This value can make investors, analysts, and lenders hesitate to support the business because of the indication of financial instability. This can happen because of taking more debts to compensate for previous losses or offering larger dividends beyond the equity of shareholders. 

Debt to Equity Ratio Example

Let’s assume Company XYZ Inc., wants to evaluate their debt to equity ratio because they need more funding from investors. The investors shall offer their interest to invest only if the company demonstrates a positive D/E ratio value. Their total liabilities amount to $500,000 and the equity of shareholders remains $400,000. Therefore the debt to equity ratio would be calculated as,

500,000 / 350,000 = 1.4

Here, the D/E ratio is 1.4. This means the lenders can offer financial assistance without fearing an impending risk. The company is experiencing positive growth so far. 

On the other hand, there could be companies with $950,000 in debt with an equity value of $150,000. Such firms will have a D/E ratio value of 6 and this indicates a risk for the investors and means the company is heavily funded by external sources.

Debt to Equity Ratio by Industry

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