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Ratios - Debt to Equity - YouTube
Channel: Else Grech Accounting
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I else here and today we're going to
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talk about the depth equity ratio this
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ratio is calculated as a business's
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total liabilities divided by the total
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equity it is used to measure the
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relationship between what has been
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contributed by the creditors in the form
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of debt and what has been contributed by
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the shareholders in the form of equity
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it measures a business's financial
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leverage the extent to which debt is
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used either aggressively or not to grow
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the business the debt to equity ratio
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gauges the degree to which a business is
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taking on debt in order to increase its
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value the increase in debt is used to
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increase the projects the businesses
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involved in and therefore increase
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future revenues increased debt is
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associated with increased risk what does
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the word risk actually mean risk is
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connected to the fact that future events
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transactions circumstances and results
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just cannot be predicted risk means
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unpredictability in the case of debt
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levels additional debt is connected to
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financing costs but also to adding value
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through growth if the financing costs
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are greater than the benefits received
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from increased growth overall
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shareholders equity will decrease
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because lower profits means lower
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retained earnings which means lower
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equity high debt to equity ratios and an
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increase in the ratio is or may be seen
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as a negative for these reasons having
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said that not all high debt to equity
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ratios are bad which is why I said maybe
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everyone who reviews debt to equity
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ratios needs to be careful and consider
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a few factors the first would be the
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industry you're looking at debt to
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equity ratios differ between different
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industries for instance industries that
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require a high level of investment in
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property plant and equipment like mining
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or car manufacturing may have much
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higher debt to equity levels then say a
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service company providing financial
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advice to their clients debt to equity
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ratios should be compared between
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businesses within the same
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stree the second consideration would be
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what liabilities are included in total
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liabilities this may differ considerably
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between different businesses some use
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only debt that requires a cash outflow
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meaning they omit unearned revenue some
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include only long-term debt which means
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they exclude all short-term liabilities
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even that can be complicated since if
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long-term debt is close to maturity the
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business may exclude it since it can be
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categorized as short-term all of these
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factors complicate the comparison of the
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debt to equity ratio it is therefore
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important to do the following determine
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how the ratio is calculated in the
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businesses you are reviewing compare
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ratios only for businesses within the
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same industry and finally compare the
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ratio to benchmarks that are available
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for the industry the business is in that
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we'll provide additional information for
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your analysis let's do an example to
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better demonstrate these concepts for
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these examples will assume that total
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liabilities is the total of all current
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and non-current liabilities here we have
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two businesses green manufacturing and
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blue manufacturing green manufacturing
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has total liabilities of 50,000 and
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total equity of a hundred thousand using
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these figures we can calculate the debt
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to equity ratio which would be 0.5 times
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or 50 percent which is 50 thousand
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divided by a hundred thousand what does
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this mean it means that for every 50
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Cent's of debt the business has $1 of
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equity the business is equity financed
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meaning that equity finances most of the
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purchase of the assets now let's look at
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blue manufacturing they have the same
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total equity of a hundred thousand but
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they have liabilities of two hundred
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thousand their debt to equity ratio is
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two times or two hundred percent
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calculated as two hundred thousand
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divided by 100,000 this means that for
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every two dollars of debt Blue has only
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one dollar of equity they are mainly
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debt financed meaning that the debt has
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financed or purchased a larger portion
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of their assets
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since both businesses are in the same
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industry we can compare them and decide
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which one we want to invest in or which
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we want to loan money to let's look at
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it another way
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greens debt to equity ratio is 0.5 times
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or 50% we know their assets are equal to
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their liabilities plus their equity so
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assets must be a hundred and fifty
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thousand dollars if we take the
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liabilities and divide them by the total
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assets and then take the equity and
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divide that by the total assets we learn
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that one dollar of assets is funded
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33.3% through debt and 66.7 through
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equity again we see that this business
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is equity financed if we do the same for
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blue manufacturing we can see that two
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times or the two hundred percent debt to
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equity ratio can be analyzed in the same
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way assets are three hundred thousand
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equal to two hundred thousand
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liabilities plus one hundred thousand
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equity if we divide total liabilities by
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the total assets and then we divide the
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total equity by the total assets we
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discover that every one dollar of assets
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is funded 66.7% by the debt and only
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33.3 by equity showing that this company
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is heavily debt financed we can then
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compare these two companies to see which
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is debt financed obviously blue and
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which is equity financed green what does
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this mean it means that blue
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manufacturing has higher risk a higher
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debt to equity ratio is considered
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riskier because it shows that the
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shareholders have not funded a large
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portion of the business's operations
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this might be seen as a lack of
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performance on the shareholders part it
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is riskier because debt requires
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interest payments and expense which
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reduces profit reduces retained earnings
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and reduces equity in the end finally
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the principal must be repaid at some
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point in the future a future where we
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don't know what the economy or the
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businesses financial position might be
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both the interest and principal
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repayments require an outflow of cash
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from
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operations reducing the cash available
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to either grow the business or pay
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dividends to the shareholders
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in addition if there's a downturn in the
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economy the cash flow from operations
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might be reduced and this can seriously
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impact the ability of the business to
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service and repay their debt you can see
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why the debt to equity ratio measures of
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businesses leverage they are leveraging
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their present in the hopes of an
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uncertain future
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companies with high debt to equity
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ratios may not be able to attract
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additional capital from either creditors
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or potential investors here's a low debt
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to equity ratio better certainly low
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debt to equity ratios are preferred by
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the investors and lenders because they
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are better protected in an economic
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downturn this is due to lower ongoing
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interest costs and lower requirements
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for principal repayments however a low
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debt to equity ratio may not be a good
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thing either why because it may indicate
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that the business is not taking
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advantage of the growth and therefore
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the increased future profit that taking
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on debt may bring remember taking on
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debt is used to increase the project's
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the business is involved in and
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therefore increase future revenues just
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because there are negatives connected
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with a high debt to equity ratio does
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not mean that a high debt to equity
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ratio is bad as we noted before we can't
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assess a debt to equity ratio without
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careful consideration of a number of
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factors remember to complete an
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appropriate analysis and make a reasoned
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and well supported conclusion thank you
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for watching my video on the debt to
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equity ratio I hope you will join me
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again for future videos about the ratios
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you
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