Growing a business requires investment capital. When companies are scaling, they need money to launch products, hire employees, assist customers, and expand operations. There are numerous ways to raise capital, and each will have a different impact on your company and the pace at which you grow.

The most common way to raise capital is through either equity or debt. But what do each of these entail?

Leverage is the term used to describe a business's use of debt to finance business activities and asset purchases. When debt is the primary way a company finances its business, it's considered highly leveraged. If it's highly leveraged, the debt to equity ratio tends to be higher.

The debt to equity ratio is a simple formula to show how capital has been raised to run a business. It's considered an important financial metric because it indicates the stability of a company and its ability to raise additional capital to grow.

It is important to note the debt to equity ratio will vary across industries. This is because different types of businesses require different levels of debt and capital to operate and scale.

For example, an apparel company that requires textiles to create the product, labor to assemble the clothing, warehouses to store their products, and brick-and-mortar stores to sell the product to customers is likely going to carry more debt than a tech company that delivers all of its products online and does not have to worry about storing physical products or maintaining a customer-facing physical space. These considerations will greatly impact the debt to equity ratio of these two companies.

Why Is Debt to Equity Ratio Important?

As an entrepreneur or small business owner, the ratio is used when you've applied for a loan or business line of credit.

And for investors, the debt to equity ratio is used to indicate how risky it is to invest in a company. The higher the debt to equity ratio, the riskier the investment.

To further clarify the ratio, let's define debt and equity next.

What is debt?

Debt is an amount owed for funds borrowed from a bank or private lender. The lender agrees to lend funds to the borrower upon a promise by the borrower to pay back the money as well as interest on the debt — the interest is usually paid at regular intervals. A business acquires debt in order to use the funds for operating needs.

A company typically needs hard assets to borrow money from a bank or private lender. A hard asset is a receivable for product or service delivered that is recognized on the company's balance sheet and shows a lender the business is capable of paying back the loan. If a company is new or doesn't have hard assets it's more difficult to borrow.

What is equity?

Equity is stock or security representing an ownership interest in a company. Put simply, it's your ownership in an asset — such as a company, property, or car — after your debt on that asset is paid.

When a business uses equity financing, it sells shares of the company to investors in return for capital. To learn more, check out this guide to equity financing.

DEBT TO EQUITY RATIO

Financial analysts and investors are often very interested in analyzing financial statements in order to carry out financial ratio analysis to understand a company's economic health and to determine if an investment is considered worthwhile or not.

The debt-to-equity ratio (D/E) is a financial leverage ratio that is frequently calculated and looked at. It is considered to be a gearing ratio. Gearing ratios are financial ratios that compare the owner's equity or capital to debt, or funds borrowed by the company.

This ratio compares a company's total liabilities to its shareholder equity. It is widely considered one of the most important corporate valuation metrics because it highlights a company's dependence on borrowed funds and its ability to meet those financial obligations.

Because debt is inherently risky, lenders and investors tend to favor businesses with lower D/E ratios. For lenders, a low ratio means a lower risk of loan default. For shareholders, it means a decreased probability of bankruptcy in the event of an economic downturn. A company with a higher ratio than its industry average, therefore, may have difficulty securing additional funding from either source.

The Preferred Debt-to-Equity Ratio

The optimal debt-to-equity ratio will tend to vary widely by industry, but the general consensus is that it should not be above a level of 2.0. While some very large companies in fixed asset-heavy industries (such as mining or manufacturing) may have ratios higher than 2, these are the exception rather than the rule.

A D/E ratio of 2 indicates that the company derives two-thirds of its capital financing from debt and one-third from shareholder equity, so it borrows twice as much funding as it owns (2 debt units for every 1 equity unit). A company's management will, therefore, try to aim for a debt load that is compatible with a favorable D/E ratio in order to function without worrying about defaulting on its bonds or loans.

A higher debt-equity ratio is not always a bad thing. Employing debt in company will have following advantages:-

No dilution in the ownership as lenders have no claim towards equity.

Tax benefit as tax paid to lenders is deducted from profits while calculation of tax liability of the company.

Lenders have no claim in the profits of the company as their claim are restricted to principal and interest.

Time saving as loans are raised in less period of time in comparison to equity.

Less compliance work in taking loan in comparison to raising capital out of market by way of issuing shares.

When the financial risk is at an acceptable level, increasing the debt-to-equity level could benefit the company through a reduction in the cost of capital. This is because when debt-to-equity level increases, the more expensive source of finance (i.e. equity) is replaced by the cheaper alternative (i.e. debt) leading to an increase in shareholder wealth.

Low debt-to-equity ratio suits companies operating under volatile and unpredictable business environments as they cannot afford financial commitments that they cannot meet in case of sudden downturns in economic activity.

As we covered above, shareholders' equity is total assets minus total liabilities. However, this is not the same value as total assets minus total debt because the payment terms of the debt should also be taken into account when assessing the overall financial health of a company.

Short-term debt consists of liabilities that will be paid in under a year. Long-term debt consists of liabilities that will take a year or under to mature. Let's walk through an example.

Company A has $2 million in short-term debt and $1 million in long-term debt. Company B has $1 million in short-term debt and $2 million in long-term debt. Both companies have $3 million in debt and $3.1 million in shareholder equity giving them both a debt to equity ratio of 1.03.

However, because short-term debt is renewed more often, having greater short-term debt compared to long-term debt is considered risky, especially with fluctuating interest rates. With this in mind, Company B would be considered less risky because it has more long-term debt, which is considered more stable.

Here's a reference to help you remember the long-term debt to equity ratio formula.

How to calculate long-term debt to equity ratio

Examples of long-term debt include mortgages, bonds, and bank debt. Just like the standard debt to equity ratio, investing in a business is riskier if it has a high ratio.

The debt to equity ratio is a valuable tool for entrepreneurs and investors, and it shows how much a business relies on debt to finance its purchases and business activities. If you're interested in entrepreneurship, learn about how to start a business next.

Ratio Analysis

Once the financial statements of an organization are prepared they then need to be analyzed. One such tool to analyze and asses the financial situation of a firm is Ratio Analysis. It allows the stakeholder to make better sense of the accounts and better understand the current fiscal scenario of an entity. Let us take an in-detail look at ratio analysis.

n finance, ratios are a correlation between two numbers, or rather two accounts. So two numbers derived from the financial statement are compared to give us a more clear understanding of them. This is an accounting ratio.

Let us take an example. The income for the year from operations is let us say 1,00,000/- for a given year. The Purchases and other direct expenses cost around 75,000/-. So the Gross Profit of the year is 25,000/-. Now it can be said that the Gross Profit is 25% of the Operations Revenue. We calculate this as

G.P. Ratio = GPSales/Revenue ×100

G.P.Ratio = 25,0001,00,000 ×100

G.P. Ratio = 25%

One factor to be kept in mind is that ratio analysis is used only to compare numbers that make sense and give us a better understanding of the financial statement. Comparing random financial accounts should be avoided.

Objectives of Ratio Analysis

Interpreting the financial statements and other financial data is essential for all stakeholders of an entity. Ratio Analysis hence becomes a vital tool for financial analysis and financial management. Let us take a look at some objectives that ratio analysis fulfils.

1] Measure of Profitability

Profit is the ultimate aim of every organization. So if I say that ABC firm earned a profit of 5 lakhs last year, how will you determine if that is a good or bad figure? Context is required to measure profitability, which is provided by ratio analysis. Gross Profit Ratios, Net Profit Ratio, Expense ratio etc provide a measure of the profitability of a firm. The management can use such ratios to find out problem areas and improve upon them.

2] Evaluation of Operational Efficiency

Certain ratios highlight the degree of efficiency of a company in the management of its assets and other resources. It is important that assets and financial resources be allocated and used efficiently to avoid unnecessary expenses. Turnover Ratios and Efficiency Ratios will point out any mismanagement of assets.

3] Ensure Suitable Liquidity

Every firm has to ensure that some of its assets are liquid, in case it requires cash immediately. So the liquidity of a firm is measured by ratios such as Current ratio and Quick Ratio. These help a firm maintain the required level of short-term solvency.

4] Overall Financial Strength

There are some ratios that help determine the firm’s long-term solvency. They help determine if there is a strain on the assets of a firm or if the firm is over-leveraged. The management will need to quickly rectify the situation to avoid liquidation in the future. Examples of such ratios are Debt-Equity Ratio, Leverage ratios etc.

5] Comparison

The organizations’ ratios must be compared to the industry standards to get a better understanding of its financial health and fiscal position. The management can take corrective action if the standards of the market are not met by the company. The ratios can also be compared to the previous years’ ratio’s to see the progress of the company. This is known as trend analysis.

Advantages of Ratio Analysis

When employed correctly, ratio analysis throws light on many problems of the firm and also highlights some positives. Ratios are essentially whistleblowers, they draw the managements attention towards issues needing attention. Let us take a look at some advantages of ratio analysis.

· Ratio analysis will help validate or disprove the financing, investment and operating decisions of the firm. They summarize the financial statement into comparative figures, thus helping the management to compare and evaluate the financial position of the firm and the results of their decisions.

· It simplifies complex accounting statements and financial data into simple ratios of operating efficiency, financial efficiency, solvency, long-term positions etc.

· Ratio analysis help identify problem areas and bring the attention of the management to such areas. Some of the information is lost in the complex accounting statements, and ratios will help pinpoint such problems.

· Allows the company to conduct comparisons with other firms, industry standards, intra-firm comparisons etc. This will help the organization better understand its fiscal position in the economy.

Limitations of Ratio Analysis

While ratios are very important tools of financial analysis, they d have some limitations, such as

· The firm can make some year-end changes to their financial statements, to improve their ratios. Then the ratios end up being nothing but window dressing.

· Ratios ignore the price level changes due to inflation. Many ratios are calculated using historical costs, and they overlook the changes in price level between the periods. This does not reflect the correct financial situation.

· Accounting ratios completely ignore the qualitative aspects of the firm. They only take into consideration the monetary aspects (quantitative)

· There are no standard definitions of the ratios. So firms may be using different formulas for the ratios. One such example is Current Ratio, where some firms take into consideration all current liabilities but others ignore bank overdrafts from current liabilities while calculating current ratio

· And finally, accounting ratios do not resolve any financial problems of the company. They are a means to the end, not the actual solution.

Solved Example for You

Q: When many year figures are kept side by side, they help a great deal in exploring the _______ visible in the business.

a. Trends

b. System

c. Difference

d. None of the above

Ans: The correct option is A. Ratio analysis can be used to compare information taken from financial statements to gain a general understanding of the results, financial positions, and cash flow of a business. Ratio analysis is useful in exploring trends of the business.

How do operating income and revenue differ?

Solvency refers to an enterprise's capacity to meet its long-term financial commitments. Liquidity refers to an enterprise's ability to pay short-term obligations; the term also refers to a company's capability to sell assets quickly to raise cash. A solvent company is one that owns more than it owes; in other words, it has a positive net worth and a manageable debt load. On the other hand, a company with adequate liquidity may have enough cash available to pay its bills, but it may be heading for financial disaster down the road.

Solvency and liquidity are equally important, and healthy companies are both solvent and possess adequate liquidity. A number of liquidity ratios and solvency ratios are used to measure a company's financial health, the most common of which are discussed below.

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6 Basic Financial Ratios And What They Reveal

KEY TAKEAWAYS

Solvency and liquidity are both equally important for a company's financial health.
Solvency and liquidity are both terms that refer to an enterprise's state of financial health, but with some notable differences.
Liquidity refers to both an enterprise's ability to pay short-term obligations and a company's capability to sell assets quickly to raise cash.

Liquidity Ratios

Current ratio = Current assets / Current liabilities

The current ratio measures a company's ability to pay off its current liabilities (payable within one year) with its current assets such as cash, accounts receivable, and inventories. The higher the ratio, the better the company's liquidity position.

Quick ratio = (Current assets – Inventories) / Current liabilities

= (Cash and equivalents + Marketable securities + Accounts receivable) / Current liabilities

The quick ratio measures a company's ability to meet its short-term obligations with its most liquid assets and therefore excludes inventories from its current assets. It is also known as the "acid-test ratio."

Days sales outstanding (DSO) = (Accounts receivable / Total credit sales) x Number of days in sales

DSO refers to the average number of days it takes a company to collect payment after it makes a sale. A higher DSO means that a company is taking unduly long to collect payment and is tying up capital in receivables. DSOs are generally calculated quarterly or annually.

Solvency Ratios

Debt to equity = Total debt / Total equity

This ratio indicates the degree of financial leverage being used by the business and includes both short-term and long-term debt. A rising debt-to-equity ratio implies higher interest expenses, and beyond a certain point, it may affect a company's credit rating, making it more expensive to raise more debt.

Debt to assets = Total debt / Total assets

Another leverage measure, this ratio quantifies the percentage of a company's assets that have been financed with debt (short-term and long-term). A higher ratio indicates a greater degree of leverage, and consequently, financial risk.

Interest coverage ratio = Operating income (or EBIT) / Interest expense

This ratio measures the company's ability to meet the interest expense on its debt, which is equivalent to its earnings before interest and taxes (EBIT). The higher the ratio, the better the company's ability to cover its interest expense.

Solvency Ratios vs. Liquidity Ratios: Examples

Let's use a couple of these liquidity and solvency ratios to demonstrate their effectiveness in assessing a company's financial condition.

Consider two companies, Liquids Inc. and Solvents Co., with the following assets and liabilities on their balance sheets (figures in millions of dollars). We assume that both companies operate in the same manufacturing sector, i.e., industrial glues and solvents.

Balance Sheet (in millions of dollars)	Liquids Inc.	Solvents Co.
Cash	$5	$1
Marketable securities	$5	$2
Accounts receivable	$10	$2
Inventories	$10	$5
Current assets (a)	$30	$10
Plant & equipment (b)	$25	$65
Intangible assets (c)	$20	$0
Total assets (a + b + c)	$75	$75
Current liabilities* (d)	$10	$25
Long-term debt (e)	$50	$10
Total liabilities (d + e)	$60	$35
Shareholders' equity	$15	$40

*In our example, we assume that "current liabilities" only consist of accounts payable and other liabilities, with no short-term debt. Since both companies are assumed to have only long-term debt, this is the only debt included in the solvency ratios shown below. If they did have short-term debt (which would show up in current liabilities), this would be added to long-term debt when computing the solvency ratios.

Liquids Inc.

Current ratio = $30 / $10 = 3.0

Quick ratio = ($30 – $10) / $10 = 2.0

Debt to equity = $50 / $15 = 3.33

Debt to assets = $50 / $75 = 0.67

Solvents Co.

Current ratio = $10 / $25 = 0.40

Quick ratio = ($10 – $5) / $25 = 0.20

Debt to equity = $10 / $40 = 0.25

Debt to assets = $10 / $75 = 0.13

We can draw a number of conclusions about the financial condition of these two companies from these ratios.

Liquids Inc. has a high degree of liquidity. Based on its current ratio, it has $3 of current assets for every dollar of current liabilities. Its quick ratio points to adequate liquidity even after excluding inventories, with $2 in assets that can be converted rapidly to cash for every dollar of current liabilities. However, financial leverage based on its solvency ratios appears quite high. Debt exceeds equity by more than three times, while two-thirds of assets have been financed by debt. Note as well that close to half of non-current assets consist of intangible assets (such as goodwill and patents). As a result, the ratio of debt to tangible assets—calculated as ($50/$55)—is 0.91, which means that over 90 percent of tangible assets (plant and equipment, inventories, etc.) have been financed by borrowing. To summarize, Liquids Inc. has a comfortable liquidity position, but it has a dangerously high degree of leverage.

Solvents Co. is in a different position. The company's current ratio of 0.4 indicates an inadequate degree of liquidity with only 40 cents of current assets available to cover every $1 of current liabilities. The quick ratio suggests an even more dire liquidity position, with only 20 cents of liquid assets for every $1 of current liabilities. But financial leverage appears to be at comfortable levels, with debt at only 25 percent of equity and only 13 percent of assets financed by debt. Even better, the company's asset base consists wholly of tangible assets, which means that Solvents Co.'s ratio of debt to tangible assets is about one-seventh that of Liquids Inc. (approximately 13 percent vs. 91 percent). Overall, Solvents Co. is in a dangerous liquidity situation, but it has a comfortable debt position.

A liquidity crisis can arise even at healthy companies if circumstances arise that make it difficult for them to meet short-term obligations such as repaying their loans and paying their employees.

The best example of such a far-reaching liquidity catastrophe in recent memory is the global credit crunch of 2007–09. Commercial paper—short-term debt that is issued by large companies to finance current assets and pay off current liabilities—played a central role in this financial crisis. A near-total freeze in the $2 trillion U.S. commercial paper market made it exceedingly difficult for even the most solvent companies to raise short-term funds at that time and hastened the demise of giant corporations such as Lehman Brothers and General Motors Company (GM).

But unless the financial system is in a credit crunch, a company-specific liquidity crisis can be resolved relatively easily with a liquidity injection, as long as the company is solvent. This is because the company can pledge some assets if required to raise cash to tide over the liquidity squeeze. This route may not be available for a company that is technically insolvent since a liquidity crisis would exacerbate its financial situation and force it into bankruptcy.

Insolvency, however, indicates a more serious underlying problem that generally takes longer to work out, and it may necessitate major changes and radical restructuring of a company's operations. Management of a company faced with insolvency will have to make tough decisions to reduce debt, such as closing plants, selling off assets, and laying off employees.

Going back to the earlier example, although Solvents Co. has a looming cash crunch, its low degree of leverage gives it considerable "wiggle room." One available option is to open a secured credit line by using some of its non-current assets as collateral, thereby giving it access to ready cash to tide over the liquidity issue. Liquids Inc., while not facing an imminent problem, could soon find itself hampered by its huge debt load, and it may need to take steps to reduce debt as soon as possible.

Special Considerations

The following points should be borne in mind when using solvency and liquidity ratios:

Get the Complete Financial Picture: Use both sets of ratios, liquidity and solvency, to get the complete picture of a company's financial health, since making this assessment on the basis of just one set of ratios may provide a misleading depiction of its finances.
Compare Apples to Apples: These ratios vary widely from industry to industry, to ensure that you're comparing apples to apples. A comparison of financial ratios for two or more companies would only be meaningful if they operate in the same industry.
Evaluate the Trend: Analyzing the trend of these ratios over time will enable you to see if the company's position is improving or deteriorating. Pay particular attention to negative outliers to check if they are the result of a one-time event or indicate a worsening of the company's fundamentals.

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