Every individual, company or corporate entity in the world, when it comes to numbers, is only as big or valuable as the total value of assets that they owns. In layman terms, ASSETS refer to properties or items that we own or have in our possession. A company would like to purchase items like Vehicles, Office Premises, Equipment, Machinery etc. Usually, in order to use them to generate income.
As private individuals, Assets that we would like to own may include, Cars, Mansions, Phones, Laptops etc. These assets can either be financed through our own savings, earnings, gifts or funds that we have borrowed from other people. This essentially means that assets can be financed in two ways; Equity and Debts.
This refers Owners’ Savings, Earnings, Contribution or Stock. When a business is formed the owners pool funds and resources together with a view using them to run the business and generate income. Sometimes a business I owned by more than one person.
Depending on the ownership structure of the business, they can be known as Partners or Shareholders. Meaning that if you purchase a company’s stock, you have not lent them money, instead, you have purchased ownership rights in the said company. You will be entitled to share profits and dividends and take losses if the business goes bad. The total contribution of the owners of a business entity is what is called Equity.
We are all familiar with the concept of debt. It refers to the portion of all Assets that we own that has been financed by others and must be repaid at an agreed future date(s). Debts can also be called Liabilities. It can either in the form of cash loans or credit purchases.
Loans are cash advances that we borrow from various external sources, e.g. Banks, Friends, close associates, spouses, or trade unions and that we have agreed to pay back at a given date, usually with a certain amount of interest.
Credit Purchase refers to an event when we purchase an item from a seller without making full and final payment for the product instantly with a promise, agreement or an arrangement to make full payment at a future date or over a period of time. There are different forms of credit purchase. Outright Credit purchase, deferred payment, Hire purchase, e.g. Mortgage.
Maturity of debt refers to the time period, according to the agreement made with the creditor regarding when repayment is expected to be made. Debts that mature within one-year are known as short-term debts. Conversely, Debts that are expected to be repaid over a period longer than one year are called long-term debts.
The Accounting Equation
In accounting terms, all that we have explained above can be summarized in the following equation;
Assets = Debt (or Liability) + Equity.
To take it one step further, we can re-write this equation as follows;
Liability = Assets – Equity: this means that total debts we owe can be derived by deducting Assets’ total value from the portion of it that was paid for by our own Earnings/Savings.
Equity = Assets- Liability: This denotes that our actual Net-worth can only be derived when we subtract all the legal claims of outsiders from the total value of Assets in our possession.
How to Calculate Debt to Equity Ratio
Debt is not entirely a negative thing, as a matter of fact, it can very well be positive, especially when it is used in appropriate proportions, effectively and judiciously.
Companies can use debts to facilitate healthy expansion. For instance, when a company takes out a loan to purchase a piece of new equipment, which can then can be used to generate a significantly higher level of income which will increase profits.
The Debt-to-equity Ratio, is a mechanism designed to keep us in check and monitor the warning signals regarding how deep in debt a company or an individual is. It shows us to which extent to which the owners’ equity can fulfill its obligations to its creditors.
Debt-to-Equity Ratio helps us to determine the following:
1) Net-Worth: many businesses and individuals are usually very happy to disclose/announce their profits or pay checks. However, a company can announce big profits but still be on the verge of collapse or bankruptcy.
The Debt-to-equity ratio is what really depicts how financially strong or healthy an entity is or will be over the next few years.
2) Control shows if the company is being controlled outsiders. Because if an entity is too heavily in debt, there is a chance that Creditors will have significant influence in its operational decisions.
3) Level of Debt also shows the quantity or monetary value of the total debts that a company/individual owes.
4) Credibility: When this measured over a period of time, it helps us to observe if the company has been repaying its debts over time or if it has been taking on new debts.
As a rule of thumb, a low debt-to-equity ratio would be less than 1. Which indicates that an entity is financing a more of its activities through its own funds vis-à-vis debts.
A high debt-to-equity ratio (greater than 1) is undesirable and would indicate the entity is raising more of its financing through borrowing money from outsiders of purchasing items on credit. Such companies can also be called highly leveraged companies.
Short-term Debt-to-equity ratio compares the owners’ equity to the portion of the company’s debts that are payable within the next year.
Long-term Debt-to-equity ratio shows the comparison between the owner’s equity and the portion of the company’s debts that is not expected to be paid back within the next one year.
- How to Interpret Debt-To-Equity Ratio
– Less than 0.5 = Low risk i.e, There is little or no risk of insolvency
– Between 0-1 = Reasonable i.e, the company is operating at within reasonable level of leverage.
– Between 1-2 = Warning i.e, the company is exceeding healthy levels of leverage
– More Than 2 = Critical i.e, total debts more than twice as the value of Owners Equity
– More than 5 = Danger i.e there is grave danger of Insolvency!
Debt-to-equity Ratio Formula
Jones & Jane Pharmaceuticals’ annual financials published last year showed the following figures:
However, the interpretation of debt-to-equity ratio threshold may vary from one industry to the other. For instance, some industries such as Oil refineries, Construction companies often make use of several large heavy-duty equipment and which are capital intensive.
This may make it essential to sometimes raise funds for the purchase of such equipment through long-term loans. In essence, a higher debt-to-equity ratio may be acceptable in this industries because percentage of income can be generate from these heavy equipment and they often last for many years of usage.
Conversely, smaller companies such as restaurants or ice cream shops may not require such large capital outlay hence a similar level of debt-to-equity ratio in such industry could sound warning bells.
In the same vein, the interpretation may also differ within the same industry, depending on the growth stage or maturity level that each company currently is. A new company may have a higher debt-to-equity ratio simply because it has only just begun operations and most of its debt obligations have not matured. As months/years go by, if it services its debts duly it is expected that the ratio would fall over time.
As a rule of thumb, Equity of an entity should always be greater than its debts in order to remain healthy and prevent insolvency. However,
Insolvency is an event where an entity is unable honor its financial various obligations such as salaries, taxes, utility bills as well as debts to creditors over an extended period of time.
This can lead to the entity being declared bankrupt by a court of law. This is because if the business runs into bad times and has not made enough revenue, it is still obligated to make certain minimum payments.
Reasons for Debts
Companies and Corporate entities may take on debts for diverse reasons.
To finance expansion: Companies often borrow money to finance expansion projects such as opening a new branch.
To purchase equipment
Companies can take out loans to finance the purchase new equipment to either replace old ones or improve current production capacity.
To improve liquidity
Sometimes a business maybe cash-strapped for different reasons. For instance some of its debtors or customers may fail to make timely payments for products, this can make the company take a small loan to cover their liquidity needs for the moment.
Interest payments on debts is deductible for tax purposes, thereby making it a less expensive and more attractive way of financing the business.
To prevent dilution of owner’s equity position and retain control of decision making powers in the business.
To Avoid Sanctions
Business are often required to make certain payments to the government’s coffers by law. Some of these payments are time-bound and failure to meet up with the set deadlines make lead to stiff sanctions such as fines, revoked license or complete shutdown of the business operation. To avoid any of these, a company that is currently short of cash may need to take a loan in order to meet up with the required payments as and when due.