Today’s financial theory of capital structure is incompetent because it does not contemplate the impact of possession structure on the value of the company. The value of a company grows with the climb in the concentration of possession so that a change in possession leads to a reduction in agency costs. It eventually results in a better alignment of the interests of managers and stockholders.
With companies that are identical but differ in the degree of ownership concentration, those with a more concentrated ownership structure have higher profitability and higher value. That’s because the owners are more interested in monitoring and controlling when making the necessary management changes.
The debt-to-equity ratio is a measure of the company’s solvency and should tell us the share of long-term debt in total long-term assets. This indicator should be compared with the previous ratio for the best results.
In particular, long-term debt that tends to go down makes the total debt increase over time. As a result, the share of short-term debt is growing. The solution should be sought in attempts to reschedule the debt to extend the repayment period, allowing the next loans to be taken out for a longer period of time.
What Is a Debt to Equity Ratio Calculator?
A Debt to Equity Ratio Calculator is a tool that will help you do what you have searched for – calculate the debt to equity ratio. Doing it manually can be slow, which will take some of your time, and we all know that time is precious.
It goes without saying that lenders want it to be as low as possible. The lower the debt-to-equity ratio, the greater the share in own funds is. This leads to less risk for creditors. It shows the extent to which a company uses debt as a source of financing.
Besides, DER can help us measure the company’s ability to service debt obligations. If it is 0.5, for example, it means that creditors (creditors) provide 0.5 funds per 1 monetary unit provided by stockholders.
DER Formula: How to Compute DER?
When calculating DER, you need to use the following formula:
DER = Total Liabilities / Total Equity
Example of the Debt to Equity Ratio
The best way to learn how the debt-to-equity formula works is with a simple example we have prepared for you. Here, you will see how it is applied in practice and how simple it is. Take a look at the data in the table and then you will find out how it’s processed in this formula.
- Total Liabilities: $100,000
- Total Equity: $100,000
DER = Total Liabilities / Total EquityDER = 100,000 / 100,000DER = 1
Now that you know how to compute DER, you should also know how it’s used in practice. So, how does it work? First, we will explain what the total liabilities and total equity are.
Total Liabilities
They show the net debt position of the company, considering cash (and cash equivalents) as a deduction from debts. Loan liabilities include two components, such as:
- Payment of periodic interest expenses, and
- Repayment of debt principal at maturity
The need to separate these components arises from differences in their accounting treatment – as a rule, interest expenses are considered an operating expense and are covered by operating profit (before taxes), while principal repayment is considered as an expense of financial activity at net profit.
This difference has its repercussions in the financial sense because the effective (actual) interest expenses are equal to the balance sheet interest expenses, which is not the case with the principal repayment expenses.
Namely, the repayment of the principal falls on the net profit, which is the amount on which the profit tax has already been paid. This means that the effective issuances of money for the repayment of principal are higher than the nominal ones, for the amount of tax paid on each dinar of periodic profit before tax. We will use a simple example to illustrate this statement.
Total Equity (Stockholders’ Equity)
It represents the value your company has. Agency borrowing costs are related to stockholder / manager-creditor conflicts and lead to a decline in the merit of the company. The main sources of conflicts of attentiveness between stockholders and creditors on bonds are as follows:
- Dividend policy (new borrowing reduces the value of bonds);
- dilution of rights (the value of creditors’ rights will be reduced by borrowing);
- The difficulty of asset substitution (when an enterprise substitutes less risky assets with assets that are riskier, the value of creditors’ rights will decrease and the value of equity will increase); and
- Underinvestment.
Creditors will, depending on the intensity of agency costs of debts, demand a premium on interest rates, thus shifting the bearing of these costs ex-ante to stockholders. Stockholders will prefer to bear additional agency costs as long as new investments increase their well-being.
What Is Solvency?
The solvency (liquidity in the long run) tells us in a little more detail about the financial obligations of the company, so in addition to current liabilities (listed in liquidity), it includes long-term liabilities -receivables (loan installments, interest, fees, deferred tax benefits, and so on). It is actually the ability to pay.
Businesses, as well as other legal entities, are solvent when it is able to settle due to payment obligations within their maturity. It is usually measured by the ratio of available funds and due payment obligations.
It can be excessive, optimal, and unsatisfactory. Excessive solvency is when all due payment obligations are covered by available funds, and in addition, there are significant surpluses of funds.
Optimal solvency is when all due payment obligations are covered by available funds and in addition, there is still a solvency margin of safety. Unsatisfactory solvency is when all payment obligations are covered by cash, but there is no solvency security reserve. The opposite of solvency is insolvency. Solvency is directly related to liquidity.
As an example, you can take a factory that had low profitability, while in terms of profitability it looked bad due to outdated technology and EU directives that later closed the market for certain products. Analyzing the company’s solvency, there were multimillion-dollar debts to suppliers and workers that led to a loss of liquidity – the inability to pay salaries, buy raw materials, and thus stop production.