Analysis of Financial Statements 5

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·         DER measures the ratio of long term or total debt to shareholder’s equity.

·         The relationship between borrowed funds and the owner’s capital is a measure of the long term financial solvency of the firm.

·         The relationship is shown by the DEBT: EQUITY ratio.

·         The DER is a financial ratio indicating the relative proportion of entity’s equity and debt used to finance an entity’s assets.

·         This is also known as financial leverage.

·         This ratio is used as a standard for judging a company’s financial standing.

·         It is also a measure of a company’s ability to repay its obligations.

·         When examining the health of a company, it is critical to pay attention to the DER.

·         If the ratio is increasing, the company is being financed by creditors rather than from its own financial sources which may be a dangerous trend.

·         The ratio is being calculated as:-

Total outside liabilities

Debt Equity Ratio = ----------------------------

                               Tangible Net Worth

 

·        Tangible Net Worth is calculated as Capital + Free Reserve –intangible assets.

·        Lower values of debt-to-equity ratio are favourable indicating less risk.

·        Higher debt-to-equity ratio is unfavourable because it means that the business relies more on external lenders thus it is at high risk, especially at higher interest rates.

·        Optimal DER is considered to be about 1 that is liabilities = equity

·        The ratio is very industry specific because it depends on the proportion of current and non-current assets.

·        The more noncurrent assets (as in the capital-intensive industries), the more equity is required to finance these long term investments.

·        DER is an important tool of financial analysis to appraise the financial structure of a firm.

·        It has important implications from the view point of the creditors, owners, and the firm itself.

·        The ratio indicates the margin of safety to the creditors.

 

Understanding through an Example


So in this example we get Equity = 100 and Debt = 400

More analysis through Different Scenarios

Interpretation-

If DER is high, the owners are putting up relatively less money of their own. It is danger signal for the creditors. If the project should fail financially, the creditors would lose heavily.

Moreover, with the small financial stake in the firm, the owners may behave irresponsibly and indulge in speculative activity. If they are heavily involved financially, they will strain every nerve to make the enterprises a success.

Ratio Preference by Banks-

·        Generally, banks prefer a ratio below 3:1.

·        In the case of SME, the ratio can be relaxed to 4:1.

·        In medium scale industries, it could be kept as 2:1 and large scale industries, it shall be 1:1.

·        The main purpose of the ratio is to ascertain the relative financial stakes or skin in the business of the owner’s vs the creditors and banks.

·        Unlike the Current Ratio where higher values are favoured, Debt Equity Ratios are considered better if they have low values.

·        Lenders feel more secured with large stake of the owners. This ratio shows the Leverage.

·        Higher the Leverage, higher the ROE.

·        Also the safety of the creditors fund is function of the value and earning capacity of the assets owned by the concern.

·        If there is no capital, who is the casualty?

·        The creditors stand to lose if the assets depreciate in value. Banks should insist that the owners have stake in the business.

·        Also it is very important to understand that DER gets different result if shareholder’s fund is subtracted with revaluation reserve, goodwill and investment in subsidiary. Let’s understand through below example;



Now we deduct revaluation reserve, investment in subsidiary and good will from shareholder’s fund we get below result-

Next we will look into DSCR (Debt Service Coverage Ratio)






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