How to analyze the ratio of debt to equity
The debt-to-equity ratio is a financial measure used to assess a company’s capital structure, more specifically, to estimate the relative proportions of a firm’s assets that are funded by debt. The debt-to-equity ratio is a quick way to gauge how much a company is leveraging and is used by financial analysts and investors. This parameter gives a certain idea of how much the company pays on bills. In general, this parameter serves to assess the financial performance of the company.
Image titled Analyze Debt to Equity Ratio Step 1
Calculate the desired ratio. The equation for this calculation is simple, you just need to divide the total debt of the company by its equity. There is nothing complicated in this, all figures can be taken from the company’s financial statements.
As a rule, only interest-bearing, long-term debts are included in this equation. Short-term debts are often overlooked, as they do not reveal the picture of the company’s use of borrowed funds to the right extent.
Some large and off-balance sheet loans should still be included in this equation. Leasing and unpaid pensions, for example, are two fairly large items on the balance sheet to include in the equation.
Image titled Analyze Debt to Equity Ratio Step 2
Conduct a superficial assessment of the company’s financial structure. By calculating the ratio of debt to equity of a company, you can get some idea of its financial condition. For example, if the ratio is 1, then the company has 50% debt. If the ratio is quite low (less than 0.3), then this is good, since the company has little debt and, accordingly, there is less risk of suffering from an increase in interest rates on loans, etc.
Image titled Analyze Debt to Equity Ratio Step 3
Consider all financial needs related to the industry in which the company operates. Generally, a high debt-to-equity ratio (above 2) is a very worrying indicator. However, sometimes this is quite acceptable – for example, in the construction business, which receives money for the implementation of projects in the form of construction loans. It turns out that the company has a high ratio of debt to equity, and at the same time – no risk of non-payment on loans, because the owners of construction sites pay for debt servicing themselves!
Determine the effect of the company’s treasury shares on this ratio. When a company issues shares, in the financial statements they are at par (and often – almost at a price of 1 kopeck per share). When the firm buys back some of its shares, the shares are recorded at the purchase price – accordingly, equity decreases, and the debt-to-equity ratio increases. Frighteningly high debt-to-equity ratios can sometimes only be the result of share buybacks.
Image titled Analyze Debt to Equity Ratio Step 5
Supplement your analysis with other financial indicators. The debt-to-equity ratio should never be used on its own. For example, if a given firm’s ratio is fairly high, then you may have reasonable concerns about how much it will cost to service that debt. In this case, you will have to conduct a deeper analysis and find out at what percentage the funds are raised, under what conditions, and also divide the income from the core activity by the cost of debt service. If operating income is high, then even a firm with a high debt-to-equity ratio will do pretty well.
Using these kinds of relationships found on financial websites, try to understand exactly what forms of debt are included in the calculation.