# Debt to Equity Ratio

Another leverage ratio used to evaluate the financial integrity of a business is the debt to equity ratio.  It is strictly a bottom half balance sheet ratio.  Its result explains the relationship of volume of debt and corresponding equity to finance the operations of a business, i.e. the purchase of assets.  What is important to understand is that certain business sectors and their corresponding industries have well established relationships of debt and equity.  Abnormalities with this relationship impact solvency  and opportunity.  For investors in business it is essential to not only understand this debt to equity relationship but also its effect on the income statement and value.   A well learned investor can take advantage of this knowledge and unlock the door to financial success while minimizing losses on poor performance investments.

This lesson starts out by explaining the formula and its derivatives.  It follows up with an explanation of leverage and its impact on financial statements.  In addition, learning to read both the cash flows statement and notes concerning debt increases the understanding of this leverage ratio.   Finally some examples are illustrated so the reader gets a practical approach towards implementing an evaluation procedure towards debt to equity.

Before continuing, there are some prerequisites to helping the reader fully grasp this ratio and understand the terminology.  I encourage the reader to first read the following:

* Debt Ratio

# Debt to Equity Formula and Derivatives

The formula for debt to equity is simply debt as the numerator and equity as the denominator as follows:

Debt to Equity Ratio = Total Liabilities
.                                    Total Equity      .

The results can vary widely.   In small business it is more common to see large amounts of debt and very little equity.  Often ratios of 3:1 exist.  A good example is a residential contractor.  Their equity position may be a couple hundred thousand dollars with total debt of a half million dollars.  Take a look at the result:

Debt to Equity = \$500,000 (Debt)      = 2.5:1
.                           \$200,000 (Equity)

Whereas a recent Exxon report identified their debt at \$12,000,0000,000 (yep, 12 billion dollars) and yet it was a mere 28%.  So here is Exxon’s formula and their equity amount:

Debt to Equity = \$12 Billion  = 28% or .28:1
.                                  ?
Debt to Equity = \$12 Billion  = \$43 Billion
.                                .28

For a major corporation like Exxon, having a debt to equity ratio of 28% is actually very high and risky especially for an oil company.   Whereas a 3:1 ratio for a small business contractor isn’t as risky.  How can this be?

The answer lies in the underlying assets and their corresponding revenue stream.  For Exxon, they process millions of barrels of oil every day.  The current price is \$48 a barrel.  If the price suddenly escalated to \$60 a barrel, profit and cash flow would soar.  On the flip side, any reduction in price per barrel will greatly impact the ability to service that debt.

Whereas the contractor appears risky, his underlying product (the construction of a home) has a very slow price swing of even 5%.  It will literally take months for the price of a home to move downward 5%.  By then, his project is complete and any losses can easily be absorbed by his equity.  In Exxon’s case a 5% downward swing can happen overnight costing Exxon millions of dollars per day.  Within a month they could lose several billion dollars greatly affecting the equity position for the shareholders.

So the lesson here is that the debt to equity ratio is not universal; the business sector and the underlying product has a bearing on what is an acceptable debt to equity ratio.

Now for some technical perspectives.  The finance industry is the real user of the ratio, especially banks.  Their definition of debt to equity is actually restricted to long-term debt to equity.   In effect they exclude short-term debt (current liabilities) from the formula.   So let’s take a look at the results for a simple medical group (practice).

GENCARE LLC
Balance Sheet (Limited Scope)
December 31, 2016

ASSETS                                                                   \$16,450,500
LIABILITIES
Current (Short-Term)                     \$2,765,200
Long-Term Debt                              8,309,700
Sub-Total Liabilities                                             \$11,074,900
EQUITY                                                                       5,375,600
TOTAL LIABILITIES AND EQUITY                    \$16,450,500

So, let’s take a look at the two versions of this ratio.

Limited Version (Banker’s Perspective)

Debt to Equity Ratio = \$8,309,700  = 1.55:1
.                                     \$5,375,600

Full Version (Technically Correct)

Debt to Equity Ratio = \$11,074,900  = 2.06:1
.                                    \$5,375,600

There is a 33% difference between the two versions of this ratio.

The reason this is important to understand is that many loan documents use this ratio as a performance tool.  Exceed a certain ratio and the note is in default.  So it is important to understand how the results are derived.   Is it all debt or just long-term debt?

A third version of this ratio is also used; it is commonly used in the service based sector.   In this sector it is normal to find current liabilities greater than long-term debt.  This is because the service sector will have very large amounts of unbilled time and receivables.  A typical \$6 to \$7 Million per year professional firm will have upwards of \$1 Million of receivables and unbilled time (similar to work in progress).  Many firms (engineering, architectural, legal and accounting) fund these two current assets with a line of credit.  The third version of this formula removes the line of credit up the accounts receivable and unbilled time value.  Any balance of the line of credit in excess of the two corresponding asset values is included in the formula.   Look at this illustration below:

SMITH AND SMITH P.C.
Balance Sheet (Limited Scope Presentation)
December 31, 2016
ASSETS
Current Assets
– Cash                                  \$346,400
– Accounts Receivable          407,750
– Unbilled Time                    107,450
Sub-Total Current Assets                       \$861,600
Fixed Assets                                                 295,700
TOTAL ASSETS                                        \$1,154,300
LIABILITIES
Current Liabilities
– Accounts Payable               \$42,325
– Accruals                               33,710
– Retainers                              43,000
– Line of Credit                     600,000
Sub-Total Current Liabilities                   \$719,035
Long-Term Debt                                           175,000
TOTAL LIABILITIES                                      894,035
EQUITY
– Capital Accounts               \$140,000
– Current Earnings                 623,265
– Draws (2016)                     (503,000)
TOTAL EQUITY                                              260,265
TOTAL LIABILITIES AND EQUITY        \$1,154,300

Debt to Equity Ratios

All Liabilities  =   \$894,035   = 3.44:1
Equity                   \$260,265

Long-Term Debt Only (Bankers Version)
Long-Term Debt  =   \$175,000   = .67:1
Equity                       \$260,265

Service Based
All Liabilities Less A/R & Unbilled Time  = \$894,035 – (\$407,750 + \$107,450) = 1.46:1
Equity                                                             \$260,265

Remember the purpose of this ratio: Is the business using debt appropriately to leverage its profit?   In the service based industry, debt is oriented around making payroll and earning profits for this service.  Over time, service driven industries should pay down debt but during growth this is difficult.  So a line of credit is exercised to meet payroll and cover accounts receivable and unbilled time.  In Smith & Smith’s case, notice the three variations of debt to equity.  The long-term debt amount is positive whereas the traditional format appears risky.  However, if the user eliminates that portion of the line of credit used to finance receivables and unbilled time, the ratio is significantly reduced to 1.46:1.  The risk factor in dollars is  118,570.  In the better managed practices, often the line of credit is well less than total accounts receivable and unbilled time.

Service based debt to equity ratios follow this table for analysis:

Ratio Range           Evaluation
0.00 to .50             Outstanding, very positive and financially comfortable
.51 to 1.10             Acceptable, risk factor is contingent on skills of staff
1.11 to 1.50            Poor and risk continues to escalate especially if one or two key individuals terminate their services
> 1.50                  Only acceptable in very large practices with a high growth rate or a niche market with their profession

Sometimes this ratio is stated in terms of coverage of total assets.  Example:  Equity is 25% of total assets, therefore debt is 75% of total assets.  Mathematically the debt to equity ratio is 3:1 (three time equity).  At 67% of debt it is 2:1.  Review this table for the various outcomes.

Debt to Equity Ratio    Debt Ratio   Equity Ratio
5:1                               83.33%           16.67%
4:1                               80.00%           20.00%
3:1                               75.00%           25.00%
2:1                               66.67%           33.33%
1:1                               50.00%           50.00%
.8:1                               44.44%           55.56%
.75:1                              42.86%           57.14%
.6:1                              37.50%           62.50%
.5:1                              33.33%           66.67%
.3:1                              23.08%           76.92%
.2:1                              13.04%           86.96%

The higher ratios bring into play the issue of leverage.

# Debt to Equity and Leverage Analysis

Leverage is a financial tool used to increase revenue at an additional cost of interest.  The primary goal is to increase the net profit.  There is a risk associated with this though.  Any downward deviation in revenue can quickly generate losses.  Look at this example.

Preston Furniture

Preston Furniture currently has sales of \$1,000,000 per year.  The gross profit margin percentage of sales is 60%.  After much debate the management team wants to leverage sales by revamping the showroom and changing the brand lines of furniture.  To successfully achieve this goal the store must borrow \$400,000 at 6% interest with a five year payback.  Annual principal and interest is \$89,000 to service the debt.  The expected increase in sales is \$200,000 per year.  Here is a simplified cash flow comparison.

Before                Leveraged
Sales                                      \$1,000,000            \$1,200,000
Gross Profit (60%)                     600,000                 720,000
Debt Service (Int. & Prin.)              –                          89,000 *
Expenses                                    500,000                  500,000
Profit                                        \$100,000                \$131,000
* Assume depreciation expense matches principal payments.

Preston’s cash flow will increase \$31,000 per year during this time period.  In the third year the economy slows causing an 8% decrease in sales.  The effect on cash flow is as follows:

Leveraged                 8% Decrease in Sales
Sales                            \$1,200,000                         \$1,104,000 (92% of Leveraged Sales)
Gross Profit                      720,000                              662,400 (60% of Sales)
Debt Service                      89,000                                 89,000
Expenses                          500,000                               500,000
Profit                              \$131,000                               \$73,400

Without leverage, Preston’s bottom line was \$100,000 per year. The 8% decrease in sales would have meant an unleveraged profit of \$52,000.  With leverage and an economic slowdown the bottom line is \$57,600 less than expected.  In effect, the debt service costs Preston \$26,600 of its original bottom line value and is only generating an additional \$21,400 of value.  This is with a mere 8% lower volume of sales than expected.

Leveraging works well in highly stable business sectors whereby sales do not fluctuate wildly.  Examples include financing, banking, insurance, real estate and geriatric care.  If you look at a bank’s financial statement, the equity position is often less than 25%; therefore debt to equity ratios are in the 3:1 or higher range.  Pull a real estate investment trust’s (REIT) balance sheet and equity will be in the 15 – 20 percent range.

Leverage which is calculated using the debt to equity and the corresponding debt ratio has another drawback.  As debt increases, lenders are more reluctant to advance more funds due to the above leverage analysis.  So any opportunities a business has to expand sales or take advantage of economic prosperity is hampered by existing leverage.  Lenders foresee increased risk and solvency issues associated with high debt to equity ratios.

# Cash Flows Statement Impact of Debt to Equity Ratio

Debt requires two elements of cash outflow.   The first is the interest associated with the loan.  The second is principal that is owed back to the lender.  Most business owners don’t include the administrative costs of handling the debt as it is often less than 1% of the total annual cash out.  It is considered negligible in the overall cash out.

The cash flows statement identifies these two elements associated with debt.  The statement is divided into three sections as described below.

1) Cash Flow From Operations – This section is the heart of cash flows and identifies the net cash flow related to the income statement and the associated current assets and liabilities.  The interest expense or cash out is reported here and separately at the bottom of the report.

2) Cash Flow From Investing – Investing activities refer to the purchases of tangible and intangible [link to article – Tangible and Intangible Assets] assets and any proceeds related to their sale.

3) Cash Flow From Financing – Long-term debt and equity (sale of stock and payment of dividends) issues are reported in this section.  Loan proceeds (inflows) and principal payments (outflows) are identified separately from equity transactions.

The cash flow from financing is the critical section related to the leverage ratios.  It will generally tie to the balance sheet, specifically the liabilities section.  To illustrate, look at the following example:

GARDEN APARTMENTS LLC
Comparative Balance Sheets (Limited Scope)
December 31, 2015 and December 31, 2016

ASSETS                                                        2015                         2016
Current Assets                                      \$483,709                   \$479,281
Fixed Assets (Net)                               2,403,745                  2,742,457
\$2,887,454                 \$3,221,738
LIABILITIES
Current:
A/P                                              \$27,381                    \$31,409
Accrued                                        82,742                       77,793
Current Portion L/T                  392,651                    196,415
Sub-Total Current Liabilities              \$502,774                   \$305,617
Long-Term Debt                                     2,100,716                  2,427,742
TOTAL LIABILITIES                              2,603,490                  2,733,359
EQUITY                                                        283,964                     488,379
TOTAL LIABILITIES & EQUITY       \$2,887,454               \$3,221,738

Notice in the current liabilities section an account titled ‘Current Portion L/T’ which means current portion of long-term debt; this dollar value represents the principal amount due on notes over the next 12 months.  Therefore the total amounts owed for long-term debt are:

2015                    2016
Current Portion                            \$392,651               \$196,415
Long-Term Portion                     2,100,716              2,427,742
Total Long-Term Debt              \$2,493,367            \$2,624,157

In the aggregate, long-term debt actually increased \$130,790.  A sophisticated reader will notice that a significant portion of the principal is due during 2016 as the current portion dollar value of \$392,651 identified in 2015 must be paid in 2016.   Since this value is 15.7% of the total, it must mean a note matures in 2016.  This can easily be confirmed by reading the long-term debt note in the notes section of the financials.

Side Note
Anytime the current portion of long-term debt exceeds 8% of all long-term debt it is a sign that a note is maturing.   Typically, current portion of long-term debt is less than 5% of total long-term debt.

Since the total debt increased from 2015 to 2016, it means Garden Apartments LLC borrowed more money.  An approximate method to determine the total new note is to add the total change between the years (\$131,000) and the current portion due from the prior year (\$393,000) for the new note value.   In this case, it appears the new note balance is \$524,000.   The financing section of the 2016 cash flows statement will have two lines in its report:

Cash Outflow (Principal Payments)                     (\$392,651)
Cash Inflow (New Note)                                          524,000
Net Cash Flow From Financing                             \$131,349

So now the question is: ‘What did Garden Apartments do with this cash?’

Remember, cash is turned into assets on the books of the business.  During 2016, the fixed assets increased \$338,712.  Since this is an apartment complex, it is safe to say that some improvements were made during 2016.   It is also apparent that \$131,000 of the new note was used along with the \$204,000 of equity increase (profits less dividends  to owners) to fund the improvements.   Here is the schedule:

Fixed Assets Change                             \$339,000 *
Loan Proceeds (Net)                              (131,000) *
Profits                                                    (204,000) *
Other Sources                                            \$4,000
* Approximately

The other sources makes sense too.  Look at the decrease in current assets from 2015 to 2016.  They decreased \$4,428.  So the additional sources is from existing current assets.   So the cash flows tie together.

To confirm the value of both notes and fixed asset changes, review the notes associated with these items. One last helpful tidbit, the fixed assets change is reported as an outflow in the investing section of the cash flows statement; i.e. cash left the company to buy more fixed assets.

By combining the information on the balance sheet, cash flows statement and the notes to the financials a reader of financial reports can grasp the underlying elements of debt and equity.   To help the reader comprehend this well, the next section illustrates a couple of examples.

# Examples of Understanding Debt to Equity Ratios

To start with let’s evaluate Garden Apartments from above.  As always, when dealing with ratios:

1)  Never rely on one single ratio to make an investment decision; AND
2) Evaluate trends and not a single year.

Since this is real estate, an investor should expect high leverage ratios since real estate is a relatively stable business environment, especially apartment complexes.  Here is a quick summation:

2015                   2016
Total Debt                               \$2,603,490        \$2,733,359
Total Equity                               \$283,964           \$488,379
Debt to Equity Ratio                    9.2:1                  5.6:1

Even with the additional debt, the debt to equity ratio improves significantly in 2016.  This is due to the profitability of the complex; again look at the increase in equity during 2016 driven by current earnings net of dividends/distributions.  The equity position almost doubles.  This is a positive sign of improvement.  An investor would ask the following questions:

1) What is the occupancy rate and its corresponding change from the prior year?
2) What exactly were the improvements made in 2016 to justify the additional debt (leveraging)?
3) When do the other note(s) mature, i.e. the schedule of principal payments?

If debt increases from one year to the next, leverage is being exercised.  Therefore, a reader of financial information should see increases in revenue and significant changes in profit.   Here is an illustration of this business principle.

CHICKEN-OF-THE-SEA RESTAURANTS {Not the Real Name}

Chicken-of-the-Sea is a regional seafood restaurant chain.  It currently has four restaurants and desires to expand to seven in one year.  To achieve this, the owner agrees to leverage the debt and personally guarantee the debt using his home equity as collateral.  The following are three years of condensed balance sheets and income statements.

2014                       2015                     2016
Assets                                 \$2,741,603           \$6,410,207          \$6,271,857
Debt (Total Liabilities)     2,610,942             6,387,655             6,292,443
Equity                                      130,661                  22,552                (20,586)
Net Sales                            \$8,406,400         \$15,643,740        \$15,602,351
Profit                                         308,763                 601,008               402,817
Profit Percentage                      3.67%                     3.84%                   2.58%
Debt to Equity Ratio               19.98:1                   283:1                 Infinite

The increase in the debt to equity ratio is a clear sign of some serious issues.  The restaurant’s goal of increasing sales worked but the per restaurant sales only increased slightly.  Look at this table for the respective results.

2014                  2015                   2016
Number of Restaurants                 4                        7                         7
Sales per Restaurant         \$2,101,600        \$2,234,820         \$2,228,907
Profit per Unit                         \$77,191              \$85,858               \$57,545

This is symbolic of the food service industry.  The first year of new restaurants create desire in diners to test the food and service.   The second year of same store sales is the critical test.   A decline in sales or lack of significant growth (>3%) indicates a customer loyalty issue and most likely a menu or quality issue.  The net profit in 2016 makes sense as now interest on the total debt is consuming the profitability.  For leverage to work sales and corresponding profits must expand by more than 10% at each level per unit (location).   In this case sales only increased 6% from 2014 to 2016.  The associated interest to service that debt ate into existing profits.  Furthermore, notice total equity is negative in 2016.  Why?

The net profit of \$402,817 in 2016 should have added to equity, but equity decreases.  This means management/owners are taking profits out of the business via dividends or distributions.  The cash flows statement’s financing section will identify this amount.  Based on the information provided it looks like they took \$445,955.  Technically, when equity is negative, a business is bankrupt.   At the least, there is insolvency issues as profits should be used to service debt principal payments.

Based on the above information, the owners need to cease taking dividends or distributions, change the quality of food/service and focus on marketing to ultimately reduce the debt and bring the debt to equity ratio below 10:1.

# Summary – Debt to Equity Ratio

The debt to equity ratio is used with the debt ratio to analyze leverage in business.  As the ratio increases, leverage is extended and risk factors (insolvency, bankruptcy and lack of opportunity) come into play.

This ratio has several versions including all liabilities identified as traditional debt to equity; a more refined version limiting the debt to long-term debt only; and industry sector versions whereby dedicated assets offset certain current liabilities eliminating those liabilities from the formula.

Another important aspect of this ratio is using this ratio as a data point in a trend and not in isolation.   Furthermore, a reader of this ratio utilizes the cash flows statement and notes to financial statements to assist in understanding the underlying amounts involved in the equation.   ACT ON KNOWLEDGE.

If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org.  I would love to hear from you.  If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.