The Pros and Cons of Using a Debt/Equity Ratio

Introduction

The debt/equity ratio is a financial ratio used to measure the amount of leverage used by a company, showing the proportion of debt versus the amount of equity that a company holds. It is a comprehensive view of how much debt is used to finance a company's assets compared to the amount of equity invested into the business. By knowing the debt/equity ratio of a business, an individual or organization can make sound investment decisions.

When considering the debt/equity ratio, it is important to understand the pros and cons associated with this financial measure. The pros can be great when the debt to equity ratio is low while the cons can be catastrophic when the ratio is high.

Pros of Debt/Equity Ratio

The debt/equity ratio is one of the most commonly used financial ratios to measure a company’s financial strength. It provides not only an indication of the company’s capital structure, but can also be used as a tool for assessing risk.

The debt/equity ratio offers numerous advantages to investors and analysts. These include:

• Quick and easy evaluation of a company's financial condition - determining a company’s debt/equity ratio is simple and requires little effort. By comparing a company’s debt-to-equity ratio to other companies in the same industry, a quick determination can be made of a company’s financial health.
• Easily compares different companies to assess risk - by comparing multiple companies’ debt/equity ratios, an analyst can easily assess which company is the most financially sound and has the least risk. Such comparison is an important part of making an informed investment decision.
• Gives multiple perspectives to evaluate operations - the debt/equity ratio can provide investors with three important perspectives on a company’s operations. These are the level of leverage of the company, how it funds its assets and how it uses debt to finance its assets.

Cons of Debt/Equity Ratio

The debt/equity ratio is an important financial measure that can help identify the amount of leverage a company is using to finance itself. While this ratio is useful for assessing the health of a business, it does have a few drawbacks.

Overestimating Debt Levels

One of the primary cons of using this ratio is its tendency to overestimate a company’s debt level. When calculating the debt/equity ratio, the debt amounts are taken from the company’s balance sheet, which includes long-term debt as well as short-term liabilities such as accounts payable. Short-term liabilities are often paid off quickly and are not an indication of the long-term liabilities or debt of the company. This can lead to an overestimate of the debt level, resulting in a higher debt/equity ratio than is accurate.

Does Not Take into Account Stock Repurchases

Another of the cons of using a debt/equity ratio is that it does not take into account the effect of share repurchases on the company’s total equity. If a company repurchases a significant amount of shares for any reason, this reduces the total equity in comparison to the total liabilities or debt. This means the debt/equity ratio may be higher than it would otherwise be if share repurchases were not taken into consideration. Therefore, it is important to factor in share repurchases when calculating this ratio.

Does Not Indicate Future Performance

Lastly, while the debt/equity ratio is useful for looking at a company’s current financial position, it does not offer any indication of its future performance. This ratio is useful for assessing the health of a business, but it cannot be relied upon as an indicator of the company’s future prospects. Other measures must be taken into account to get a full picture of a company’s future potential.

Impact of Debt/Equity Ratio

Investors often use the debt/equity ratio as an indication to decide how to invest in a company. The debt/equity ratio expresses a company's financial leverage. A higher debt ratio indicates higher financial risk. As such, potential investors take debt/equity ratio into account when assessing possible investments.

Can Influence Potential Investors to Decide Whether to Invest

The debt/equity ratio may influence potential investors’ decisions. Those who prefer to limit their exposure to financial risks are likely to be more wary of investing in companies with higher debt/equity ratios. Similarly, investors who are confident in a company’s ability to manage debt obligations may be more comfortable with higher ratios. Thus, investors can use the debt/equity ratio as one of the criteria when deciding whether to invest.

Can Increase Cost of Capital When Debt Ratio Is Too High

The higher the company's debt ratio, the greater the cost of capital due to the increased financial risk. This additional cost is known as the 'leverage effect', wherein a company has to pay a premium to obtain capital. Financial institutions incorporate this premium in the cost of debt and this can drive up the total cost of capital if the debt ratio is too high.

Can Help to Assess Company's Ability to Handle Debt Obligations

A debt/equity ratio is a key indicator of a company's ability to manage debt obligations. Companies with a high debt ratio are regarded as a higher risk than companies with a lower debt ratio. Investors can use the debt/equity ratio to assess a company's financial standing and determine if the company is capable of meeting its debt obligations.

• Low debt ratio is an indicator of strong financial standing
• High debt ratio indicates high risk
• Debt/equity ratio can help determine ability to manage debt obligations

Different Perspectives on Debt/Equity Ratio

The debt/equity ratio (D/E) is a critical measure of financial health for all companies, but it is especially crucial for those who are looking to reduce their risk profile and increase the longevity of their operations. While the importance of this ratio is well-recognized, how to interpret it, and how large it should be, are subject to debate. Different perspectives, accounting choices, industries, and goals can all require different levels of D/E.

Different Accounting Choices Can Change Ratio

The way in which a company chooses to calculate its debts and equity can have a profound effect on its D/E ratios. Depending on the interpretation, a difference in one number can have a significant impact on the final calculation. As such, opinions can vary widely on the exact levels at which a company should operate. Careful consideration of the factors that go into the calculation should be undertaken before deciding on a target.

Different Industries Often Have Different Satisfactory Levels

The optimal D/E ratio is highly industry-dependent. Generally speaking, industries with more expensive capital investments and fewer eventual rewards, like the agricultural sector, tend to operate at higher D/E ratios than those with less costly investments that generate larger returns, like the technology sector. Companies are wise to consider their industry when deciding on an ideal level of D/E.

Short-Term vs Long-Term Goals May Require Different Levels

A company's goals can also play a role in how it chooses to set its D/E ratio. For example, if a company is looking for a quick exit for its shareholders, it may opt for higher levels of debt to leverage a higher multiple. On the other hand, if a company is aiming for a longer-term, stable growth strategy, lower debt levels may be the better option.

Uses of Debt/Equity Ratio

The debt/equity ratio is an important tool for financial analysis and can be used for a variety of purposes. The ratio provides an understanding of a company's financial health, and how much debt it has compared to its equity. Here are just a few ways that the debt/equity ratio can be used.

Can Help with Mergers or Acquisitions

The debt/equity ratio can be used by companies that are considering a merger or acquisition. It helps them get a better understanding of the financial risk associated with the acquisition. A higher debt/equity ratio may indicate more debt, and more financial risk, which could affect the decision to move forward with the transaction.

Can Factor into Buy/Sell Decisions for Stock Investors

For stock investors, the debt/equity ratio can be a useful tool to weigh the potential of a company's stock. A higher ratio may indicate that the company is leveraging more debt to fund its operations, which could lead to greater risks. Stock investors should take the debt/equity ratio into account when deciding whether to buy or sell a stock.

Can Provide Monitoring of Company/Portfolio Performance

The debt/equity ratio can be used to monitor the performance of a company over time. If the ratio is significantly increasing, it may be an indication that the company is taking on too much debt, and may not be able to weather a financial storm. Companies and investors alike can use the debt/equity ratio as a key metric to monitor performance.

Conclusion

The debt-to-equity ratio is a tool used by financial professionals to gauge a company’s financial health and ability to repay debts. It can also be used to compare a company’s profitability relative to its debt levels. However, it is important to use this tool in conjunction with other measurements to gain a full view of a company’s financial standing. And due to the varying perspectives of key stakeholders, there can be pros and cons depending on how a company is utilizing the ratio.

For acquirers, lenders, and creditors, understanding the debt-to-equity ratio is useful in determining the risk of lending funds. If a company has a high debt-to-equity ratio, indicating high risk, lenders may be hesitant to extend financing and acquirers may not be so inclined to purchase the company. But, for a company’s management, a higher ratio can potentially be favorable since debt can be used to finance opportunities for growth. Ultimately, understanding the potential uses, including the pros and cons, of the debt-to-equity ratio can help key stakeholders make informed and beneficial decisions.