Question

What does it mean if a company's debt-to-equity ratio shows a decrease from 1.06 to 1.59. And should shareholders be worried if this happens? Why? What can the company do to improve this situation. (write a paragraph)

Answer 1

MEANING

The Debt-to-Equity ratio (D/E) indicates the proportion of the company’s assets that are being financed through debt. Debt to Equity ratio is a long term solvency ratio that indicates the soundness of long-term financial policies of the company.

Debt-to-equity ratio 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 debt/equity ratio. 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. Lenders and investors usually prefer low debt-to-equity ratios because their interests are better protected in the event of a business decline.

A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense.

If a lot of debt is used to finance increased operations, the company could potentially generate more earnings than it would have without this outside financing. If this were to increase earnings by a greater amount than the debt cost (interest), then the shareholders benefit as more earnings are being spread among the same amount of shareholders. However, the cost of this debt financing may outweigh the return that the company generates on the debt through investment and business activities and become too much for the company to handle. This can lead to bankruptcy, which would leave shareholders with nothing.

Optimal debt-to-equity ratio is considered to be about 1, i.e. liabilities = equity, but the ratio is very industry specific because it depends on the proportion of current and non-current assets. The more non-current the assets (as in the capital-intensive industries), the more equity is required to finance these long term investments.

Steps to improve above situation

Companies can take steps to reduce and improve their debt to capital ratios. Among the strategies that can be employed are increasing sales profitability, better management of inventory and restructuring debt.

The debt to capital ratio is a financial leverage ratio, similar to the debt to equity (D/E) ratio, that compares a company's total debt to its total capital composed of debt financing and equity. This metric provides an indication of a company's overall financial soundness, as well as revealing the proportionate levels of debt and equity financing. A value of 0.5 or less is considered good, while any value greater than 1 shows a company as being technically insolvent.

The most logical step a company can take to reduce its debt to capital ratio is that of increasing sales revenues and profitability. This can be achieved by raising prices, increasing sales or reducing costs. The extra cash generated can then be used to pay off existing debt.

Another measure that can be taken to reduce the debt to capital ratio is more effective management of inventory. Inventory can take up a very sizable amount of a company's working capital. Maintaining unnecessarily high levels of inventory beyond what is required to fill customer orders in a timely fashion is a waste of cash flow. Companies can examine the days sales of inventory (DSI) ratio, part of the cash conversion cycle (CCC), to determine how efficiently inventory is being managed.

Restructuring debt provides another way to increase capital and reduce the debt to capital ratio. If a company is largely financed at high interest rates, and current interest rates are significantly lower, the company can seek to refinance its existing debt at lower rates. This will reduce both interest expenses and monthly payments, improving the company's bottom-line profitability and improve cash flow.