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Lesson 9: Solvency Ratios, Debt to Equity Ratio

Solvency Ratios, Debt to Equity Ratio

Solvency Ratios, Debt to Equity RatioAfter to have seen in the previous article the Debt Ratio, we continue our path analysing another Solvency Ratio: the Debt to Equity Ratio. The Debt to Equity is a ratio that compares the Total Liabilities to Total Equity. It measures how much of the company is financed by its debt holders compared with its owners and is another measure of financial health. Higher debt to equity ratio indicates that more creditor financing (bank loans) is used than investor financing (shareholders).

The Debt to Equity Ratio, as said, is a Solvency Ratio. Solvency Ratios, I repeat once again, are used to measure a company’s ability to meet its debt and other obligations. The solvency ratio indicates whether a company’s cash flow is sufficient to meet its short-term and long-term liabilities. The lower a company's solvency ratio, the greater the probability that it will default on its debt obligations.

Here is the formula for the Debt to Equity Ratio:

Debt to Equity Ratio, Solvency Ratios, Fundamental Analysis

 

The ratio is just, debt divided by equity. However, what is classified as debt can differ depending on the interpretation used. Therefore it is essential to be clear about what types of debt and equity are being used when comparing Debt to Equity Ratios.

A less than 1 ratio indicates that the portion of assets provided by stockholders is greater than the portion of assets provided by creditors. A greater than 1 ratio indicates that the portion of assets provided by creditors is greater than the portion of assets provided by stockholders. A ratio of 1:1 is usually considered satisfactory for most of the companies

Like most financial ratios, solvency ratios must be used in the context of overall company analysis. Investors need to look at overall investment appeal and decide whether security is under or overvalued. Debt holders and regulators might be more interested in solvency analysis, but they still need to look at a company’s overall financial profile, how fast it is growing and whether the firm is well-run overall.

 

Example

A company has total liabilities in the amount of $ 80,000 and equity in the amount of $ 70,000. This gives a debt to equity ratio of 1.14. 

Debt to Equity Ratio, Solvency Ratios, Fundamental Analysis

 

A debt to equity ratio of 1.14 is not uncommon. However, there is no specific optimal capital structure for a company. What is optimal for one company might not be right for another. There needs to be a balance between debt and equity financing. Debt financing typically offers the lowest rate. However, too much debt financing is rarely the optimal structure, as debt has to be paid back even when the company is going through troubled times.

In the next article, we will see the third and last Solvency Ratio: the Interest Cover Ratio.

 

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