What Is A Good Debt to Equity Ratio? A Singaporean Guide To Financial Health
September 18, 2023
Running a business profitably demands a delicate balance of experience and analysis. As day-to-day operations take over, it often occurs to founders the importance of breaking down the company into bare numbers to gain foresight.
Various metrics can be derived from a running business to analyse its performance, and the debt-to-equity (D/E) ratio is one such financial comparison that provides vital insights into the health of a business.
As entrepreneurs, this metric guides business owners in making informed decisions during expansion opportunities. Additionally, the ratio helps evaluate its financial leverage and assess the overall credibility of the business.
By understanding the D/E Ratio, investors and business owners evaluate the risk of investing in the company and its future.
What Is Debt To Equity Ratio?
The debt-to-equity ratio is stipulated by dividing the total debts by its shareholder equity. By drawing this comparison between two metrics, the D/E ratio informs us of the dependence a business has on debt financing.
For investors, this is a crucial metric to understand the financial risk involved when considering an investment in a company. Moreover, it guides business owners in analysing their competitors in the market and foresees potential risks that may jeopardise the company.
How To Calculate Debt To Equity Ratio?
The formula relies on comparing the total debt balance on the financial statement with the value of total shareholder equity.
Total Debt: The debt component of a company is the sum of money borrowed on a short-term or long-term basis, debt items on the balance sheet, and any other liabilities the business owes in a financial year.
Total Equity: The first component in equity is the money its owners have invested in their business. For growth, businesses raise capital from private investors or capital markets. Lastly, all profits retained since the company’s inception are considered a part of the equity pool.
The debt-to-equity ratio formula is:
Debt to Equity Ratio = Total Company Debt/Total Shareholder Equity
Interpreting Debt To Equity Ratio
Assessing the debt-to-equity ratio in the context of the business sector it operates is the correct method to interpret the D/E ratio.
This ratio provides insights and helps businesses analyse their overall financial health, project their financials, and assess risk, among many more.
When analysing the D/E ratio of your business, always compare results with companies in the same industry as yours, considering business models differ depending on the industry.
For example, it’s common for banks to have a high D/E ratio. Their business model relies on borrowing money, which it lends to its customers at higher interest rates.
High D/E Ratio: Understanding Financial Leverage Risks
When a company relies on debt funds to finance its business, we can conclude that the company has a high debt-to-equity ratio. The liabilities and equity on a balance sheet represent the claims creditors and owners have on the assets of a corporation.
For instance, if a medium to large-scale business with a high debt-to-equity ratio has to liquidate for unforeseen reasons, a large amount of the proceeds will be used to cut back on liabilities first. In this scenario, shareholders would receive a reduced value for their stake in the company.
Furthermore, in some cases, shareholders can limit the company to raise surplus credit after their round of funding to safeguard their ownership value. A contract clause such as this is understood to be a deterrent for owners to keep their loans and cash flows in check.
When a company needs funds for its next growth phase, raising capital with a high debt-to-equity ratio can increase the risk for lenders and investors. This is because the high D/E signals the company is in financial distress.
There are chances that it may reach a juncture where it starts defaulting on its creditors.
An upside to having a high debt-to-equity ratio is that a business can deduct its loan interest on the company tax returns, thus utilising tax shields to its benefit.
Low D/E Ratio: Evaluating The Pitfalls Of Overreliance On Equity Financing
A low debt-to-equity is not a sign of relief for businesses because it signifies that the business operations are functioning on the back of equity financing.
This situation also puts the company at risk of a leveraged buyout. To add, equity funds can be expensive to spend if not kept under check when compared to debt financing.
Relying on equity financing is an inefficient way to grow a business. An average business loan in Singapore accrues interest at 4-7%. In comparison, the return on investment expected by shareholders is always on the upper side.
What Is A Good Debt-to-Equity Ratio?
A good debt-to-equity ratio depends on the industry the business is operating within. Since there are upsides and downsides to both scenarios, interpreting a good debt-to-equity ratio should be analysed basis business needs and goals.
One of the pros to having a low debt-to-equity ratio is its financial leverage and health to support operations.
It allows lenders and investors to feel confident lending or investing in the corporation. Its cons being the business is unable to gain tax benefits due to low or absence of debts in its balance sheet.
In contrast, a high debt-to-equity ratio makes the business a riskier investment in the event of liquidation, as creditors get the upper hand.
Hence, good debt-to-ratio equity is a balance that a leadership team maintains based on their industry.
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What Is Negative Debt-to-Equity Ratio?
Upon reviewing the company ledger, if there are surplus liabilities in comparison to assets, it indicates a negative debt-to-equity ratio. As shareholders see their equity reduce over time, it pushes the business owners to file for bankruptcy to safeguard their interests.
There can be various reasons for negative shareholder equity:
- Dividend Payouts: Following periodical timelines, owners can choose to process significant dividends to their shareholders. It could deplete retained earnings of the business, resulting in a negative balance.
- Amassed Losses: The company can replenish its net income or retained earnings against the losses it incurred over time. In this scenario, a financial statement can declare a net loss that must be carried forward to the subsequent ledger as negative earnings, thereby reducing net profits.
- Loaning Money: If the management chooses to take out a loan to cover accumulated losses rather than issuing new shares through equity funding, the balance sheet may reflect negative shareholder equity. In this scenario, borrowing money to zero down on losses will offset the equity, reflecting a negative balance.
Understanding Debt To Equity Ratios In Singapore
As a reference, D/E ratios for Singaporean firms usually range from 0.5 to 1.5, meaning owners prefer and tend to run their company with a balanced mix of debt and equity financing. However, this may differ depending on the industry within Singapore.
Here are a few factors that often influence the D/E ratio of a company:
- Industry Type: The capital requirement of a company depends on the industry. For instance, sectors like real estate and construction exhibit a high D/E ratio due to the initial investment required to kickstart any project in this domain.
- Interest Rates: When borrowing money, considering the ongoing interest rates on business loans is an essential metric to analyse the cost of the debt.
- Company’s Growth Phase: In the early stages, any company requires an initial capital investment to kickstart operations. During this phase, owners choose to borrow money, resulting in high D/E ratios.
A company with high profitability may leverage retained earnings to facilitate operations, maintaining a lower D/E ratio.
Case Studies Of D/E Ratios In Singaporean Companies
Here we will analyse industry sectors with a high, low, or negative D/E ratio. These examples are only for explanation purposes and don’t represent the specific situations of companies in Singapore:
- High D/E Ratio: A logistics company in Singapore will need heavy capital investment. The company would turn to creditors to expand its fleet and establish a regional presence, resulting in a relatively high D/E ratio of 2.5x.
- Low D/E Ratio: A mature, cash-rich manufacturing company in Singapore might maintain a conservative D/E ratio of 0.4, indicating its preference for utilising retained earnings instead of debt to finance investments.
- Negative D/E Ratio: Singaporean companies may report a negative D/E ratio when a firm possesses more cash and equivalents than the total debt. For example, a technology firm with significant cash reserves and minimal debt might have a negative D/E ratio of -0.2.
Debt To Equity Ratio Modeling Exercise
Framing assumptions like inflation and market conditions correctly is a fundamental step in projecting the future financial performance of a company, estimating risk, and forecasting large-scale projects.
To comprehend this better, consider a hypothetical soap manufacturing business and list its assets, liabilities, and their subsequent values:
- Cash and Cash Equivalents = $60 million
- Accounts Receivable (AR) = $80 million
- Inventory = $70 million
- Property, Plant, and Equipment (PP&E) = $120 million
- Short-Term Debts = $50 million
- Long-Term Debts = $75 million
From the above, we calculate the following:
Total Assets = $210 million + $120 million (PP&E) = $330 million
Total Liabilities = Short-term debt + Long-term debt = $125 million
Equity = Total Assets – Total Liabilities
Therefore, the equity that will remain on the balance sheet for year one is $205 million.
Debt to Equity Ratio Calculation
The D/E ratio for the first year will be calculated basis of the D/E ratio formula. Hence, for year one, the D/E ratio of the company will be 0.6x
Debt to Equity Ratio = $125m/$205m = 0.6x
The ratio of 0.6x implies the company depends on less debt financing or borrowed money for every dollar of equity.
Correctly interpreting the D/E ratio requires context and industry comparison to help in financial planning, financial literary, and financial decision-making. Different sectors and industries have varying norms and acceptable debt levels, which means that a “good” D/E ratio in one industry might not be suitable for another.
The debt-equity (D/E) ratio provides valuable insights into a firm’s capital structure, financial leverage, and overall risk profile.
While typical D/E ratios can serve as valuable references for assessing financial leverage, it’s essential to recognise that each company’s situation can differ. Understanding the factors influencing D/E ratios within the diverse landscape of Singapore’s business environment helps stakeholders make informed decisions about financial health and risk assessment.
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