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Debt to Equity

Analyzing Firms

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The debt to equity ratio measures the proportion that assets are funded by debt or by an equity investment, or shareholder’s funds. This measure can indicate future problems with a company’s stability, and solvency.

Debt allows firms to boost the asset base without diluting shareholder control or revenues. The return on assets increase generates profit, the debt generates interest costs. If the return on assets exceeds interest profit from debt financing will exceed the interest cost. If a business is doing well, debt can increase profits for shareholders. During upswings in business, there is a high chance of return on assets exceeding interest. During business downturns, there is a low chance of return on assets exceeding interest. This means that interest costs exceed profits from using debt, and earnings leave the business as interest payments. Debt boosts earnings during upswings and lowers earnings during downswings.

If the debt to equity ratio is high, the firm will generate greater profit per shareholder during the firm’s business cycle upswings. The interest payments eat a higher percentage of low profits if the trend goes sour. If the debt to equity ratio is low, the firm will not be using debt to boost profits during upswings, but will easily meet interest payments, if they exist, during downturns. The key to debt as a boost to return on assets is in moderation. A firm’s debt level should be in between the two measures, enough debt to comfortably boost profits, but not enough to sink the firm during market downswings.

Debt to equity should only be compared to other firms in the context of industry or competitors. Some industries require high capital investments into assets. These firms require heavy outlays into plant, property, and equipment. Manufacturing and Airlines are examples. These firms will typically have higher debt to equity levels. Other firms, like internet or service companies, do not require heavy capital investments into plant, property, and equipment. These firms will typically have low debt to equity levels. The comparison of debt to equity should only be made amongst firms in the same industry, but typically it is better to accept a moderate or low debt to equity than a higher level.

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