Difference Between Debt Ratio and Debt to Equity Ratio

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.

CONTENTS
1. Overview and Key Difference
2. What is Debt Ratio
3. What is Debt to Equity Ratio
4. Side by Side Comparison – Debt Ratio vs Debt to Equity Ratio
5. Summary

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

Total Debt

This comprises of short term and long term debt

Short-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 Debt

Long-term liabilities are payable within a period exceeding one year

E.g. Bank loan, deferred income tax, mortgage bonds

Total Assets

Total assets comprise of short term and long term assets.

Short-term Assets

Generally referred to current assets, these can be converted to cash within a one year period.

E.g. Accounts receivable, prepayments, inventory

Long-term Assets

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?

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.

Reference:
1. “What is the difference between the gearing ratio and the debt-to-equity ratio?” Investopedia. N.p., 16 Dec. 2014. Web. 16 Feb. 2017.
2. Gallo, Amy. “A Refresher on Debt-to-Equity Ratio.” Harvard Business Review. N.p., 13 July 2015. Web. 16 Feb. 2017.
3. Thakur, Arun. “Top 10 famous companies that went bankrupt.” TopYaps. N.p., 02 Jan. 2013. Web. 16 Feb. 2017.
4. “Debt/Equity Ratio.” Investopedia. N.p., 29 Sept. 2015. Web. 16 Feb. 2017.
5. Saint-Leger, Randolf. “What Industry Typically Has the Highest Debt-to-Equity Ratios?” Budgeting Money. N.p., n.d. Web. 17 Feb. 2017.

Image Courtesy:
6. “Debt-to-asset ratio and debt-to-equity ratio chart” by PROU.S. Department of Agriculture (CC BY 2.0) via Flickr