What does the Debt/Equity ratio indicate?

An important measurement of a company's financial health is the Debt/Equity ratio. In an earlier article, I had discussed about assessing a company's financial health by calculating the 'Current ratio' and 'Quick ratio'.

The usually applicable definition of the Debt/Equity ratio is:

Debt/Equity ratio = Total debt / Shareholder's equity

Total debt includes both short term and long term debt, such as, secured and unsecured loans, mortgage payments. Shareholder's equity includes equity shares and reserves. (Preference shares can be a part of debt or of equity, depending on the terms of issue.)

Accountants some times use 'total liabilities' instead of 'total debt' in the Debt/Equity ratio to assess a company's true financial health. There is logic behind such a definition. But we will use the commonly accepted definition mentioned.

What does the Debt/Equity ratio indicate? It measures how much money a company can borrow over the long term without running into payment problems. When a company keeps borrowing, its fixed costs keep increasing due to the interest payments.

Is that a bad thing? Not necessarily. A newly formed company and/or one that is on a high-growth path may not be able to raise much equity capital because of lack of track record or the state of the stock market (or because it has already raised a lot of equity). Recourse to debt may be the only option for growth and survival.

As long as the interest and principal repayment costs can be covered by the cash generated from operations, there should be no problems at all. A company that can earn 17% on every Rupee invested and is able to borrow at 12%, will be foolish not to borrow when business is good. Every additional Rupee earned after fixed costs are covered, goes straight to profits.

Trouble starts when a company tries to grow too fast too soon and takes on too much debt. When the going is good, it can make bumper profits. During a business downturn, the high fixed costs can reduce the earnings drastically. And if a company has a long receivables cycle, or huge inventory (like in manufacturing and retail) then it may face difficulty in making payments, and to make matters even worse, need to borrow more (a la Pantaloon).

Ideally Debt/Equity ratio should be less than 1, and the lower the better. But this is a thumb-rule. For certain industries like auto manufacturing, the ratio can be 2 or more. One needs to make peer comparison in a sector or industry to arrive at typical ratios.

Bloated equity can obviously lower the Debt/Equity ratio. Is that good or bad? Given a choice, I'd prefer a company with high equity than one with high debt. Why? There are no fixed costs involved with equity shares. If business is good, more dividend payout may be involved. If business is bad, dividend payment can be slashed. Interest payments due to high debt will need to be paid regardless.

There are downsides to bloated equity. With too many shares available in the market, stock prices tend to stay depressed. Also, each individual shareholder may end up with a smaller percentage of the company's equity if shares are issued to FIIs and private equity investors. This should not affect small investors holding a couple of hundred shares.

Too small an equity capital restricts the ability of a company to borrow large sums of money. Most loans are sanctioned as a percentage of shareholder's equity. That is why you may find a huge bonus issue (like 5:1 or 10:1) preceding a company's intention to take on a big loan - for growth or an acquisition.

What about companies with Debt/Equity ratio close to zero? These are usually stalwart businesses that have been around for years and generate a huge amount of cash flow from operations. FMCG companies are a good example. Because they are in a mature sector, growth is typically in single digits. Taking on additional debt is meaningless, because internal accruals may be sufficient for any expansion.