It takes money to make money. Financial capital is necessary for a company at its inception and continues to be necessary as the business goes about its day-to-day operations. This capital can come from various sources, but this article will focus on debt and equity and how this proportion affects a business.
The D/E Ratio Defined
The debt to equity (D/E) ratio is one that indicates the relative proportion of equity and debt used to finance a company's assets and operations. Technically, it is a measure of a company's financial leverage that is calculated by dividing its total liabilities (or often long-term liabilities) by stockholders' equity. Essentially, the debt to equity ratio showcases the answer to a very basic question all business owners face -- will you finance your company by borrowing money or by selling off shares of its ownership?
Debt Financing vs. Equity Financing
A debt to equity ratio of 1.00 indicates that a company finances its activities with an equal amount of equity and debt. A value higher than 1.00 indicates that a company utilizes more debt financing than equity financing. The values used in the calculation of the debt to equity ratio are generally taken from a company's financial statements -- specifically the balance sheet. In some cases, the market values for a company's outstanding debt and shareholders' equity are utilized.
Put simply, a company that is interested in aggressively financing its operations through borrowing will have a higher debt to equity ratio. The act of increasing the ratio is known as leveraging up or gearing. While your business can certainly benefit -- even thrive -- from borrowing heavily, the obligation of periodic payments always brings about a level of risk.
Good and Bad Ratios
Each situation is different, but the ultimate goal for a company when issuing debt is to bring in profits that exceed the amount it must repay. As mentioned, increasing debt liability will bring about increased risk. This can affect the reputation of a company in the eyes of potential investors and lead to more difficulty in obtaining future financing -- via debt or equity. Increasing debt will also lead to a higher risk of bankruptcy, since the company must make periodic interest payments even when income is down.
Financing with equity -- or selling shares of ownership and profit-sharing in your company -- does not bring with it any required payments. However, this action does force a business owner to relinquish a certain amount of control. In this circumstance, others have a vested interest in the direction of the company that must be satisfied.
A debt to equity ratio of 0.30 or below is generally considered to be good because it indicates a company is exposed to less interest rate risk. A lower ratio will also lead to a better business credit rating.
Effect of Industry and Circumstance
Appropriate debt to equity ratios are dependent upon the industry in which your business operates. For example, companies that operate in industries that are heavily dependent upon financial capital, such as auto manufacturing or construction, can have debt to equity ratios of 2.00 or more. Such companies do not face as much risk of insolvency as one making, say, personal computers. The latter company would want to have a lower ratio -- somewhere around the aforementioned 0.30.
The appropriate debt to equity ratio is also determined by the circumstances an individual business faces. For instance, a young company going through the growth and expansion phase of its business may choose to borrow less due to the higher volatility in earnings it faces. On the other hand, a more established company in its maturity phase may find a higher amount of debt more palatable.
When determining the amount of debt financing that is appropriate for your business, always remember to look at the ratios of your competitors and other companies in similar industries and circumstances.
As mentioned above, the primary impact of a higher debt to equity ratio is a higher level of risk. This risk comes in many forms, but typically relates to the increased payment obligations that come with more debt.
As with any business risk, a trade-off exists. While the influx of capital from debt may lead to higher production levels and more substantial profits, there is no guarantee that this will be the case. Moreover, the more debt a company has, the harder (and more expensive) it will be to obtain new debt. Therefore, detailed and realistic planning and forecasting is always necessary when contemplating a new round of capital financing.
Examples of the negative impact that can be brought about by an increasing debt to equity ratio are the Chapter 11 bankruptcy filings of companies such as:
- R.H. Macy in 1991
- Trans World Airlines in 2001
- Great Atlantic & Pacific Tea Company (A&P) in 2010
- Midwest Generation in 2012
These companies were unable to meet their payment obligations when they experienced times of diminishing revenue.
A Complex Decision
No formula exists that can be applied to any decision-making process with regard to debt financing. Each industry is different and every circumstance unique. The pros and cons vary, but the need for an intensive study of them is constant. Examine your industry, your competition and your long-term goals and pursue a debt to equity ratio that fits your individual needs and expectations.