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.