Debt to Equity Ratio

Debt to Equity Ratio

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A quick note on using Debt/Equity Ratio to quickly gauge the company’s finances.

To my thinking, Debt to Equity basically gives an idea on how the company’s assets are financed: Through debt, or through the shareholders.

 

TYPES OF DEBTS

There are a few type of debts. There are good debts which is basically free money – money the company owed to suppliers, to depositors, to insurance policy holders. All else being equal, a company that has a healthy business and financial position where these “lenders” are accepting of the money they’re owed but paid in due course… then free is good.

So are interest-incurred debt. Owe little enough, owe at a reasonable level, and using others’ money to leverage your commercial genius… what could be better? Owe the banks enough, but not enough that you owns them, and you will go bankrupt… or raise new equity.

 

TYPES OF EQUITY

There are reserves for this and that. There are minority interests in the company. But the two main types of Equity investors should look at, particularly when they want to gauge the debt/equity ratio and what it really mean… are Contributed Equity and Retained Earnings (or Accumulated Losses).

C.E. are all the equity/cash shareholders has contributed over the years for new shares in the company.

R.E, or losses, are the profits or loss the company has retained over the years.

 

INTERPRETING DEBT/EQUITY RATIO

I think it’s worth to also look into what makes up that Equity.

Bankers tend to know what they’re doing so they usually won’t be lending above a certain ratio of debt to equity. I mean, if most of the company’s assets are funded by the bankers, they might as well buy the whole company. So they would generally be looking into this aspect.
Reason you’d want to break down the equity is to see what makes up most of that equity… Retained Earnings (i.e. profit kept back after paying dividends). Or made up mostly of Contributed Equity – new cash from issuance of new shares/dilution.
If Con.Equity keeps rising over the years… the debt/Equity ratio can remain constant at whatever “safe” level… and it’s still a pretty bad business to get into.

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