Debt to equity ratio: All you need to know
Growing a company into a successful business operation is a daunting task even when the macroeconomic conditions are working in its favor. And this is definitely not the case at the moment. Just as companies were coming out of the unprecedented challenges brought on by the COVID -19 pandemic, they were suddenly met with insufficient availability of important raw materials and goods. Then, the Russian invasion of Ukraine caused a shortage in the delivery of oil and natural gas, resulting in a drastic increase in prices and exuberant electricity costs. Now, companies and consumers alike have to modify their behavior in order to adjust for soaring inflation that in many countries is expected to reach double-digits.
To make well-informed and timely decisions about their operations, companies need to have a realistic and accurate picture of their financial and operational state. One key metric to gauge the financial stability of any organization is the debt to equity ratio. It is calculated by dividing the total liabilities of the company by its shareholders’ equity/net worth. It offers a good representation of businesses’ stability, and likely it is to have problems servicing its existing debt. This is especially relevant as many Central banks have started increasing their interest rates as a way to keep inflation in check, potentially resulting in companies having to make higher debt payments.
Startups and SMEs (small and medium-sized enterprises) struggling to cope with the external pressure could try to improve their positions by consulting with professional financial advisors or insolvency practitioners, such as Hudson Weir. The experts will take into account the unique circumstances of the business and help it get its debt back to manageable levels while charting a course through the current financial difficulties.
Debt financing
To understand the debt to equity ratio, it is vital to know what each of its components means. To fund their operations, expand their market share, scale a product, or diversify their business activities, companies need to have the necessary financial resources. However, they cannot wait to naturally gather the amount from their existing operations, as doing so could take an unreasonable amount of time and lead to massive potential losses.
One of the common ways to acquire funds is through debt financing received from external sources, such as bank loans, institutional or individual lenders, etc. However, this financing comes at a cost, which is typically represented by regular interest payments. Companies in better financial health and with promising products are more likely to be approved for and receive debt financing at better terms than businesses viewed as riskier investment choices.
Shareholders’ equity
In general, equity can be described as the total value of a company after all of its debts and liabilities have been subtracted. It is the total amount of money that the company would be able to return to its shareholders if it was liquidated. One of the main aspects in which equity differs from assets is that the assets of a company may also involve certain liabilities. Typically, financial analysts use the shareholders’ equity when trying to evaluate the state of a company’s health and stability. It is possible for companies to have negative equity. This occurs when the total value of the business’s debts and liabilities surpasses the total value of shareholders’ equity.
What is a good debt to equity ratio
Usually, the lower the debt to equity ratio is, the better state the company is in. Ranges between 1 and 2 are considered to be an ideal spot. However, it is important to take into account the specific industry of the business, as some are inherently more capital-intensive than others. The financial and manufacturing industries, for example, often have higher ratios of over 2 due to the need for more financing that companies acquire through debt. That is why when interpreting the ratio for a specific company, it is important to factor in the other businesses in the same sector.
Higher debt to equity ratio is a sign that the company relies heavily on debt financing for its growth. This makes them heavily reliant on their operations to produce enough money to cover their existing obligations. At the same time, ratio that is closer to zero indicates that the business has not borrowed much debt to finance its operation. This is not necessarily a positive outlook, as investors could view it as an indicator that the company is not fully realizing its potential and is missing value and profits by not scaling and increasing its operations.
