Key Difference – Debt Ratio vs Debt to Equity Ratio
Companies pursue various growth and expansion strategies with the intention of making higher profits. Financing such strategic options is often analysed using capital requirements where a company can use equity, debt or a combination of both. The majority of the companies attempt to maintain a suitable mixture of debt and equity to obtain benefits of both. The key difference between debt ratio and debt to equity ratio is that while debt ratio measures the amount of debt as a proportion of assets, debt to equity ratio calculates how much debt a company has compared to the capital provided by shareholders.
What is Debt Ratio
Debt Ratio is a measure of the company’s leverage. Leverage is the amount of debt borrowed as a result of financing and investing decisions. This provides an interpretation of what proportion of assets are financed using debt. Higher the debt component, higher the financial risk faced by the company. This ratio is also referred to as debt-to-assets ratio and is calculated as follows.
Debt Ratio = Total Debt / Total Assets *100
This comprises of short term and long term debt
These are the current liabilities that are due within one year’s time
E.g. Accounts payable, interest payable, unearned revenue
Long-term liabilities are payable within a period exceeding one year
E.g. Bank loan, deferred income tax, mortgage bonds
Total assets comprise of short term and long term assets.
Generally referred to current assets, these can be converted to cash within a one year period.
E.g. Accounts receivable, prepayments, inventory
These are non-current assets that are not expected to be converted into cash within one year’s time
E.g. Land, buildings, machinery
Advantages of Debt Financing
Provide lower interest rates
The interest rates payable on debt is generally lower compared to the returns expected by equity shareholders.
Avoid over-dependency on equity financing
Equity financing is costly compared to debt financing since tax savings can be made on debt while equity is tax payable
Disadvantages of Debt Financing
Investor preference for low geared companies
Many companies have been declared bankrupt due to the massive amounts of debt they have taken including some of the world’s most popular companies such as Enron, Lehman Brothers and WorldCom. Since high debt signals high risk, investors may be hesitant to invest in such companies
Restrictions in obtaining finance
Banks give special attention to the existing debt ratio before granting new loans since they may have a policy of not lending to firms that exceed a certain percentage of leverage.
What is Debt to Equity Ratio
Debt to equity ratio is a ratio used to measure a company’s financial leverage, calculated by dividing a company’s total liabilities by its shareholders’ equity. This is commonly referred to as ‘Gearing ratio’. The D/E ratio indicates how much debt a company is using to finance its assets, relative to the amount of value represented in shareholders’ equity. This can be calculated as,
Debt to Equity Ratio= Total Debt / Total Equity *100
- Total equity is the difference between total assets and total liabilities
Debt to equity ratio has to be maintained at a desirable rate, meaning there should be an appropriate mixture of debt and equity. There is no ideal ratio as this often varies depending on the company policies and industry standards.
E.g. A Company may decide to maintain a Debt to equity ratio of 40:60. This means that 40% of the capital structure will be financed through borrowing whereas the other 60% will comprise of equity.
In general, higher the proportion of debt; higher the risk; thus, the amount of debt is predominantly decided by the risk profile of the company. Businesses that are enthusiastic about taking more risks are likely to use debt finance compared to risk-averse organizations. Further, companies pursuing high growth and expansion strategies also prefer to borrow more in order to finance their growth within a relatively short period of time.
What is the difference between Debt Ratio and Debt to Equity Ratio?
Debt Ratio vs Debt to Equity Ratio
|Debt Ratio measures debt as a percentage of total assets.||Debt to Equity Ratio measures debt as a percentage of total equity.|
|Debt Ratio considers how much capital comes in the form of loans.||Debt to Equity Ratio shows the extent to which equity is available to cover current and non-current liabilities.|
|Formula for Calculation
Debt Ratio = Total debt/Total assets *100
Debt to Equity Ratio = Total debt/Total equity *100
|Debt Ratio is often interpreted as a leverage ratio.||Debt to Equity Ratio is often interpreted as a gearing ratio.|
Summary – Debt Ratio and Debt to Equity Ratio
The difference between debt ratio and debt to equity ratio primarily depends on whether asset base or equity base is used to calculate the portion of debt. Both these ratios are affected by industry standards where it is normal to have significant debt in some industries. The financial sector and capital intensive industries such as aerospace and construction are typically highly geared companies.
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