debt equity: Calculating The Ratio

2007-03-08 10:33:40

( Financial )



So often we think that companies have become bankrupt because of “creative accounting” – but more often than not, it’s really the case that they have taken on too much debt.

So, if you are a company in crisis, or an investor, you really need to know about debt vs equity and debt and equity financing.

If you are an investor, it’s not always easy to understand a company’s debt situation. But to start with, debt ratios are a good way to assess the company’s fundamental health. If you look at the debt ratio in context over a period of time, it can signal a deepening debt problem. If as an investor you can recognize these situations you can save a lot of money. One particular debt ratio – the debt equity ratio is very useful to understand.

Why is looking at debt so important?
Debt ratios won’t tell you much about the company’s earning performance or growth prospects, but they are vital if you need to gauge the company’s balance sheet durability. For example, if a downward cyclical phase or recession is imminent, it is more important for you as an investor to ascertain balance sheet strength. It is this which decides whether the company’s financial position is strong enough to survive a difficult period. An over-extended firm will be punished by financial markets at the beginning of a recession. Why? Because those debt-leveraged companies have to pay their interest obligations from a declining or flat income level. If the firm is unable to pay for their debt, they go bankrupt. If they struggle to pay, they lose their credit worthiness and later on face even more financing troubles. Even if the debt seemed manageable, shrinking profits make them look terribly burdensome.

Calculating debt equity
The debt equity ratio gives you the best idea about a company’s leverage. The formula?
Total Liabilities over Total Shareholders Equity. Shareholder equity is common stock added to firm losses of profits.

Simply speaking, the higher the figure is, the greater the leverage of the company. This ratio employs ALL liabilities (both short- and long-term) as well as ALL the owners’ equity (retained earnings and invested capital).

Interpreting the Ratio
If your long-term debt is equal to your equity, you are in a safe position. If your equity is much less than your long-term debt, you are in big trouble. For example, if your equity is double your debt you can say your company uses $0.50 liabilities added to every $1.00 of equity.
If you have no debt, you could miss an opportunity to finance projects which give better returns than the debt costs you. If, on the other hand, you have a lot of debt, your shareholders are very vulnerable because the creditors have to be compensated first if you go bankrupt. The bigger picture is that debt is alright, if you have enough equity.
Note to Chantelle – word count here is 482


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