Debt to Equity Ratio - Essay Example

Debt to Equity Ratio Many people assume debt to be a bad thing that should be avoided. The public relates debt to high interest rates, credit card bills and to some extent even bankruptcy. In reality, when one runs a business, debt is not as bad as the public may assume it to be. In most cases both investors and financial analysts want companies to use the debt facilities to finance their businesses since entities need high capital to improve their operations and initiate new investment projects to generate more revenue in the future. The debt to equity ratio is a measure, which is commonly used to determine the amount of debt used to run a business. The ratio simply indicates the amount of debt an entity has on every dollar of equity. The debt to equity ratio is one of the leverage ratios, which firms use to determine their extensive use of debt. The equity might make someone think that the ratio is only used to determine the debt extensiveness in a publicly traded company but this is not the case as the ratio is applicable to all entities. Any company that has debt should pay close attention to this ratio as investors usually refer to it on their investment decisions. The calculation of the debt to equity ratio is as straightforward as its definition. The ratio is computed by taking an entity’s total liabilities and dividing it by the company’s equity. The total liabilities and equity used are got from the statement of financial position of the company on discussion. A company’s equity is the amount of capital the shareholders or owners of the business have put in the business. It is determined by subtracting the total liabilities from the company’s total assets. It is best if the debt to equity ratio is kept within a reasonable range. If the ratio is very high, it is an indication that the business can be in a financial distress and maybe in leverage problem where it can find it had to offset its debtors. On the other hand, if the ratio is to low, it implies that the company is heavily relying on the entity’s equity to finance its operations. Running an organization on equity is very costly and efficient. This makes it undesirable. A low debt to equity ratio exposes an entity to the risk of a leverage buyout. Businesses have two means of financing their operations, raising money either from equity or by borrowing funds from lenders (Bull, 34). Loans acquired from lenders come with an interest payment, which must be paid together with the principal loan amount. The advantage of financing a company’s operation through debt finance is that the company can deduct the interest payments in its tax returns. On the other hand financing the company’s operations through equity makes the company at an obligation to earn return and increase the shareholder wealth. Company’s should therefore strike a balance between the debt and equity use to run the operations of their businesses. The debt to equity ratio is a useful tool that is used to determine this finance mix. A moderate debt to equity ratio differs from one industry to another depending on the capital intensity in an industry. As a rule of thumb, companies in technology-based industries are expected to have a debt to equity ratio of two and below because they indulge in many research and development activities. Companies in large manufacturing industries have a debt to equity ratio of between two and five. A ratio above this point makes investors to be nervous of the company’s leverage. Companies in the finance sector can have their ratios reach 10 and above though it is unlikely to witness such a situation (Bull, 37). Ford and GM’s debt to equity ratio between the years GM’s debt to equity ratio was 2.85 to 1 in 2013 and 3.93 to 1 in 2014. The debt to equity ratio is at an unacceptable level in both the years. This is because the company’s is in the large manufacturing industry where a debt to equity ratio of between 2 to 5 is acceptable. There has been an increase in the ratio in between the two-year period. This implies that the company has increased its reliance in debt to finance its operations as compared to equity finance. The increase in debt will have advantage to the company, as the company will offset its interest payment on the debt in its tax returns. The company’s increase in debt will make the investors demand more return on their investors since an increase in debt increases the risk related to their investors in the company. Ford’s debt to equity ratio was 6.72 to 1in 2013 and 7.38 to 1 in 2014. The debt to equity ratio in both the years is undesirable. This is because the company is in the large manufacturing industry where a debt to equity ratio of above five is undesirable. Despite the ratio being undesirable, it has increased in between the two years worsening the situation. This ratio implies that the company is heavily geared putting its investors nervous since they consider their investments very risky making them demand more return. Comparison of the debt to equity ratio of GM and Ford Both the debt to equity ratio of GM and Ford has increased in the two-year period. This implies that both the two companies saw the need to increase their debt to finance their operations as opposed to raising money through equity. This was a positive measure for both companies, overlooking the gearing ratio. The companies increase in debt will make the company raise additional capital without having the liability to increase the shareholder wealth and returns. The interest payments from the debt finance are tax allowable expenses that the companies can use to deduct from their taxable income. Both the companies are in the large manufacturing industry, which considers a debt to equity ratio of between two and five as acceptable. This implies that GM has a better debt to equity ratio than Ford. The high debt to equity ratio of Ford will pose threats to potential investors who will seek high returns for their investments to cover their risk. Work cited Bull, Richard. Financial Ratios. Oxford: CIMA, 2008. Print. Read More