Debt to equity ratio

Introduction

The development of the world economy has determined the existing variety of sources, forms and conditions for attracting borrowed capital. The company attracts borrowed capital through government agencies and private financial institutions, which currently include credit organizations, pension and investment funds, and insurance companies. Borrowed capital can be obtained from partner enterprises. Effective management of borrowed capital in the capital structure of an enterprise can provide additional income to its business turnover, increase the profitability of the production process itself, and increase the market value of the enterprise.

This determines the relevance of the topic of the work. First of all, borrowed funds are necessary to finance growing enterprises, when the growth rate of their own sources lags behind the growth rate of the enterprise, to modernize production, develop new types of products, expand their market share, and acquire another business. Inflation and a lack of own working capital force most enterprises to raise borrowed funds to finance working capital. The advantage of financing through debt sources is the reluctance of owners to increase the number of shareholders, shareholders, as well as the relatively lower cost of credit compared to the cost of equity capital, which is expressed in the effect of financial leverage.

Ciaran Walsh's Three Methods

So, dear colleagues, in the previous article*, speaking about methods for analyzing the structure of companies’ financing sources, we focused on the idea of ​​Ciaran Walsh** that one of the most important indicators of corporate finance, indicating the financial stability of companies, is the debt ratio ( “debt to equity” ratio, D/E), that is, the ratio of debt and equity capital.
Although this coefficient, writes Walsh, is used everywhere, it, unfortunately, goes under many different names, and is calculated in different ways ([1], p. 128). Note: * See the material “Analysis of the structure of the company’s liabilities: assessment of the volume of its borrowed capital” in issue 4 (April), page 32 of “BUKH.1S” for 2021 and on the website https://buh.ru/articles/documents /47541/. All articles by Professor M.L. Pyatov on this topic can be found on the website https://buh.ru/ under the tag “financial analysis”. ** Ciaran Walsh is Chief Financial Officer at the Irish Management Institute in Dublin. He is dual-trained in Economics (BA Economics) and Accounting (Fellow of the London Institute of Professional Management Accountants - CIMA). Before starting his academic career, he was engaged in business in industry for 15 years. The main topic of K. Walsh's research is establishing connections between a company's growth, its capital structure and its value on the stock exchange. (According to K. Walsh. Key indicators of management - Kyiv: Companion Group, 2008).

According to Walsh, the idea behind this ratio is very simple - to establish the ratio of different methods of financing reflected in the balance sheet, and also to compare the amount of equity and borrowed capital. However, when implemented in practice, this idea causes certain difficulties due to the ambiguity of the interpretation of the concept of “borrowed capital” ([1], p. 128).

So, for example, in Russia V.V. Kovalev and Vit.V. Kovalev define borrowed capital “(debt capital, long-term debt) as funds provided on a long-term basis to an economic entity by third parties (i.e., not the owners of this entity) or the state. … Borrowed capital,” the authors continue, “is mainly represented by long-term bank loans and bond issues” ([2], p. 270). On the contrary, A.D. Sheremet adheres to a broader interpretation of this concept, referring to borrowed capital virtually the entire volume of funds raised by the company ([3], pp. 217, 309, 314).

In an attempt to “remove terminological difficulties” ([1], p. 128), Walsh invites us to consider three possible definitions of the term “debt capital” “made on the basis of common understanding” ([1], p. 128). These options involve recognition as “loan capital” ([1], p. 128):

1. only long-term obligations;
2. long-term and short-term loans, that is, all borrowings on which interest must be paid;
3. the total total debt of a company, that is, long-term liabilities and all current liabilities of the company.

These approaches can be represented on the balance sheet diagram as follows:

Other types of funds at the enterprise

But the capital structure of the organization is not limited to the above types of funds. For example, there is the presence of retained earnings, which is formed after the formation of all mandatory cash trust funds of the enterprise, settlements of mandatory payments and settlements with shareholders. Thus, the resulting retained earnings become temporarily free capital. The decision to use this capital is made differently by each enterprise. For example, it can be used to increase the reserve capital fund, etc.

The list of capital classifications can be continued. Therefore, elucidating the question of the essence of capital has worried thinkers for centuries, which has led to the emergence of many theories of capital. They are all true and false within a certain context. But one thing is absolutely clear: the success and development of an enterprise largely depends on the efficiency of using capital investments.

When thinking about a draft business plan, for example, a business plan for a bakery cafe with calculations, it is important to understand how much funding you are counting on and what structure is expected.

It's all a matter of point of view

“It should be noted,” Walsh notes, “that the first two definitions [of the option] apply only to debts on which interest must be paid to a bank or other financial institution.
And the third definition [option] covers a larger number of components: in addition to borrowing from banks or other financial institutions, this also includes loans from suppliers, all types of accrued payments, such as dividends, taxes, etc.” ([1], page 128). Unlike domestic authors, Walsh, not being so categorical in choosing the “correct” definition of the concept of “borrowed capital,” evaluates its options based on the interests of specific groups of users of reporting data.

“It is understandable,” writes Walsh, “why bankers resort to a narrower interpretation of the concept of “borrowed capital.” Typically, their claims against the debtor are satisfied earlier than the claims of suppliers and other creditors. ... From the bank’s point of view, the category of “borrowed capital” can only include those obligations, other than bank ones, that must be satisfied at the same time or earlier than the bank’s requirements” ([1], p. 128).

Let us recall that currently in Russia, according to paragraphs 1, 2, 3 of Article 64 of the Civil Code of the Russian Federation:

“If you look at it from a company's perspective,” Walsh continues, “their debt to the supplier is just as real and important as the debt to the bank.
Therefore, when calculating the ratio of equity capital to borrowed capital, it is quite fair to include all types of debt in the amount of borrowed capital” ([1], p. 128). At the same time, Fr. However, in his opinion, “although these articles may be of interest for scientific research and discussion, in practice they do not cause serious difficulties, since their proportion is insignificant and they cannot seriously affect the final results” ([1], p. 128 ). This opinion, expressed by Walsh in 2006, continues to be relevant, in particular, for modern Russian practice. This, for example, confirms what E.V. Ladnyuk study of reporting data of Russian companies in 10 sectors of economic activity for 2013 - 2014 ([4], pp. 33-56). E.V. Ladnyuk, based on data from the SPARK information and analytical system, a random sampling method was used to select the reports of 100 companies classified by the system as large and medium-sized. According to the data obtained, the share of deferred tax liabilities in the balance sheet currency does not exceed 4 percent ([4], p. 41).

Based on the fact that any type of company debt is important for its managers, Walsh suggests using a broad definition of the concept of “borrowed capital” when analyzing the structure of a company’s sources of financing, proposing three ways to calculate the “debt ratio.” At the same time, looking at Russian textbooks on financial management, we would say that he offers methods for calculating various analytical coefficients ([5], pp. 281-284). But Walsh assumes “that, in the end, the method of calculation is not so important, since the end results indicate the same coefficient” ([1], p. 130). “There are not many relatively independent financial ratios that are fundamental to a company,” Walsh continues. And the debt ratio, or the ratio of debt to equity, is just one of them, although it sometimes seems that it comes in many different types” ([1], p. 130).

Fixed and working capital

In addition to the authorized capital, to a certain extent, the guarantor of the financial stability of the enterprise is fixed capital , which includes:

• buildings and constructions;
• expensive equipment;
• cars;
• Construction in progress;
• long-term investments.

Thus, it can be seen that fixed capital is the least liquid form of capital (that is, exchanging it for money (liquidity) can cause difficulties).

Working capital represents funds intended for the purchase of raw materials, consumables, payment of wages, etc. This capital is consumed during one production cycle, in contrast to the main one, the “consumption” of which is carried out over several years.

Working capital may include both direct funds intended for servicing the production cycle (purchase of raw materials, production, sales, etc.), and funds invested in:

• raw materials;
• fuel and energy components;
• materials and semi-finished products;
• unfinished production;
• finished product inventories;
• goods for resale.

Three and three more

So, Walsh offers us three methods for calculating the indicator, which he calls the “debt ratio” ([1], p. 130):
1. Finding the ratio of debt to equity:

Debt capital / Equity capital.

2. Finding the ratio of equity capital to total capital:

Owner's Equity / Total Assets.

3. Finding the ratio of total borrowed capital to total capital:

Borrowed capital / Total assets.

At the same time, based on the importance of information about the structure of sources of financing the company’s activities and the varying degrees of riskiness of the company’s long-term and short-term obligations as sources of its capital, this indicator can be supplemented by presenting the share of each of the three types of sources of funds in their total volume.

Thus, the following can be calculated:

1. Share of own sources of funds in the total volume of financing of the company’s activities:

Capital and reserves / Total balance sheet liabilities.

2. Share of long-term liabilities in the total volume of financing of the company’s activities:

Long-term liabilities / Balance sheet liability total.

3. Share of short-term liabilities in the total volume of financing of the company’s activities:

Short-term liabilities / Balance sheet liability total.

Additional and reserve capital

The above types of capital funds are usually mandatory and exist regardless of the type of activity in any enterprise. However, an indicator of the actual reliability and stability of an enterprise can be called the presence of additional and reserve capital . These funds are formed mainly in the form of additional reserve funds in case of need to cover unexpected losses or losses.

The formation of additional capital occurs through the annual deduction of a certain amount (usually about 5 percent) from net profit. The additional funds fund, as a rule, is not allowed to be used for the purposes of current production consumption.

Easy to calculate, difficult to interpret

As noted by V.V.
Kovalev and Vit.V. Kovalev, the growth in the share of attracted sources of funds in their total volume in dynamics “is, in a certain sense, a negative trend, meaning that from a long-term perspective, the enterprise is becoming more and more dependent on external investors. There are different, sometimes opposing, opinions regarding the attraction of borrowed funds in foreign practice. The most common opinion is that the share of equity capital in the total amount of long-term sources of financing should be quite large. The lower limit of this indicator is also indicated - 0.6 (or 60%)" ([2], p. 321).

“The more debt a company has,” Walsh writes, “the greater its risk. All debts shown on the balance sheet represent creditors' claims on assets. … [At the same time, situations are common when] it turns out that in the end it is cheaper for a company to borrow than to obtain the funds it needs in the form of additional share [equity] capital. By increasing the amount of debt on its balance sheet, a company can typically achieve increased profitability, the market price of its shares rises, shareholder wealth increases, and new opportunities arise to expand the scale of the business” ([1], p. 132). Let us add on our own that this effect also applies to any other (in terms of organizational and legal form) commercial company.

Where is the limit of prudent risk? Walsh encourages us to think.

“It is very difficult,” he writes, “to calculate how much shareholder returns will increase [from raising debt capital]. … Most companies have to operate in conditions of uncertainty. We have found, the author continues, that companies with fairly predictable future profits, for example, renting out part of their real estate, usually have a lot of debt. And companies operating in volatile industries, such as mining, are more likely to rely on equity capital. In addition, he notes, the study revealed both geographic and industry differences in approaches to companies' debt levels. Thus, in US and UK companies a more conservative approach to debt prevails than in EU countries. With a conservative approach, it is almost impossible to find companies whose debt-to-equity ratio exceeds 60%, and in EU countries there are companies whose ratio reaches 70% or more” ([1], p. 132).

Here it is worth recalling a very conservative statement on this issue, belonging to Leopold A. Bernstein, who represents precisely the American approach to decision-making in this area.

“Despite heated debate, especially in academic circles,” writes Bernstein, “whether the price of capital of an enterprise changes with different structure of its capital, that is, with different ratios of debt and equity capital, the problem seems much clearer from a third party point of view , such as a lender or investor, who must make a decision under real-world conditions. In the case of two companies that are identical in all other respects, a lender will be at greater risk if it lends to a company that has 60% debt (and 40% equity) than if it lends to a similar company that receives, say, only 20% of borrowed funds” ([6], p. 448).

The answer to the question about the optimal ratio of equity and debt capital in a particular company does not have a clearly “correct” answer. This is the area of ​​decision making by managers of a particular company, which are influenced by many factors. Here is the country where the action takes place, the size of the company, the industry of its activity, the stage of development of the company, plans for its future activities, conditions for attracting borrowed capital and much, much more.

Eugene F. Brigham and L. Gapenski recommend that we focus on the average ratio of equity and debt capital in the industry, assessing the “normality” of this ratio for a particular company in comparison with the industry average ([7] , page 180).

It is interesting that one of the most famous authors today in the field of investment business valuation, Aswath Damodaran, speaking about analytical indicators representing the structure of companies’ sources of financing, generally bypasses the topic of their criterion values ​​([8], pp. 68-70). The same position is shared by the famous German professor dealing with issues of enterprise economics, H. Schierenbeck ([9], pp. 741-742).

Authorized capital

The first step when creating any large enterprise is the formation of authorized capital , which becomes a kind of “foundation” of the organization. Most often, the presence of a certain amount of authorized capital is a mandatory requirement established by the state when creating certain organizational and legal forms of enterprises (for example, a limited liability company), but, according to experts, the creation of such a fund should not be neglected for small enterprises.

It is the presence of authorized capital that guarantees the financial stability of the company. Its value varies depending on the characteristics of the enterprise’s activities and organizational and legal form. Thus, the authorized capital can be formed through:

• contributions of the participants of the enterprise at the time of its creation;
• official share price;
• share contributions;
• other monetary fund (for example, funds allocated by government agencies).

Moreover, the amount of such capital is established at the time of formation of the enterprise (mainly on the basis of legally established requirements) and cannot change (especially decrease) in the future.

So well forgotten old

Discussion of the question of what should be the ratio between equity and debt capital of a company has a very long history and has never been characterized by simplicity and unambiguous decisions.
So, for example, in the famous work of Z.P. Evzlin's 1927 “Technique for Determining Creditworthiness” ([10]), the author aptly calls ratio analysis of financial statements the “method of ratios” ([10], p. 54), among “eleven ratios or credit barometers, as they are called Americans” highlighted “the ratio of all debts of an enterprise to its net capital” ([10], p. 54). “The ratio of the entire debt of an enterprise to its own funds,” wrote Evzlin, “determines its financial stability for a longer period. It is obtained by simply dividing the total amount of debt on the balance sheet by the amount of the company's own funds. Its purpose is to determine the ratio of equity and borrowed capital circulating in a given enterprise and, consequently, the degree of interest of the owners. What should be the value of this ratio depends on the industry or trade to which the enterprise under study belongs, and, in order to determine how normal the resulting ratio is in the enterprise under study, it is necessary to compare it with the relations existing in other similar enterprises. If it is large, it jeopardizes the profitability of the enterprise, since its income may not be sufficient to pay interest on the amounts borrowed. As a general rule, the total amount of debts should not exceed the amount of the enterprise's own funds; no one can claim that others risk more than himself; the only exceptions are railroads and banks; the former usually own enormous property, which fully covers their debt, and in addition, their profitability is not subject to strong fluctuations; the functions of the latter are to mediate and regulate credit operations; their distinctive feature is that they work with borrowed capital.

Naturally,” Evzlin continued, “an enterprise whose liability-to-equity ratio is not high is in better condition than an enterprise whose ratio is high. A small equity capital, if the business is successfully conducted, ... should not serve as an obstacle to bank lending to the enterprise; You should treat with distrust only those enterprises where the equity capital, although large, is incorrectly allocated. “A favorable sign,” Evzlin pointed out at the end, “should be considered for an enterprise when a comparison of its balance sheets gives a gradual increase in equity and a decrease in borrowed funds” ([10], p. 60).

The famous German balance expert Paul Gerstner, whose book “Balance Sheet Analysis” was published in the USSR in 1926 ([11]), wrote: “The mutual relationship [of one’s own and other people’s funds] shows the greater or lesser reliability of the financial basis of the enterprise” ([11], p. 269-270). “The most reliable enterprise,” he argued, “is one that is able to work only with its own funds. But in joint stock companies this is a rare exception. ... Our joint stock companies, on the contrary, often operate with very little fixed capital and extensive credit. This is a very dangerous and unhealthy way of doing business, although it is justified by the need to expand the enterprise to generate more income. ... Every enterprise, Gerstner insisted, must strive to ensure that the total amount of other people's funds is in a normal ratio to the amount of its own. ... The smaller the amount of other people's funds in relation to one's own, the stronger and more reliable the enterprise. The minimum limit is the complete absence of other people’s funds, and the maximum is the approximate equality of other people’s and one’s own funds” ([11], pp. 269-278).

In the remarkable book “Operational Analysis of an Enterprise,” a translation of which from German was published in the USSR in 1930 ([12]), Gerstner’s opponent Kurt Schmaltz, about ([12], p. 179), wrote: “If Gerstner says: “the lower the amount of other people’s funds in relation to one’s own funds, the more reliable the enterprise,” then this thesis is valid only within certain limits. There is also a minimum limit on the amount of someone else's capital, completely independent of the issue of profitability. ... To fix the normal ratio of one’s own capital to someone else’s capital, as is often done, should be considered an unacceptable generalization, despite the fact that in the literature the ratio of 1:1 is considered the extreme limit of the ratio of one’s own capital to someone else’s capital” ([12], pp. 180-181 ).

“The limit,” continued Schmaltz, “also depends to a large extent on the traditional views of the whole country and its financial circles. What is still considered possible in Germany may no longer be considered financially impossible in America” ([12], p. 181).

Summarizing

In general, capital is the unit with which any entrepreneurial activity begins. Therefore, accounting, an analytical department, a financial and economic division, and the presence of an investment specialist are all structural divisions of an enterprise, one way or another designed to manage the flow of capital assets of the enterprise.

Much attention to issues related to the formation of the capital structure should be paid at the enterprise planning stage. Depending on the specifics of the business, a completely different ratio of the size of fixed and working capital is possible; often it will be quite advisable to have borrowed capital, and sometimes it is better to get by with only your own.

In order to avoid making mistakes when planning future activities and, in particular, the part devoted to the formation of the capital structure, we recommend a ready-made business plan with a clear composition of all the necessary sections and a convenient financial model. You can also order the development of an individual turnkey business plan based on the characteristics of your company.

Where does balancing your own and borrowed funds begin?

Generally speaking, balancing equity and borrowed funds begins with... increasing the level of organization of business processes within the enterprise. Using an instrument such as financial leverage, that is, increasing the volume of resources managed by an organization using borrowed funds, is similar to increasing bets in gambling: the higher the bets, the higher the possible winnings, but even in the event of a loss, the losses will be greater. This can be done safely and profitably only with a high level of management, planning and management accounting, production efficiency, when there is complete confidence that every ruble taken will be invested in the right assets that circulate at the optimal speed, and there are no ineffective costs.

Next, it is advisable to determine the company’s financial strategy by answering the following questions:

1. What return on equity does the company provide?
2. Are the owners satisfied with the income they receive?
3. Are there any plans to withdraw significant sums from the business in the medium term—exceeding net profit? If yes, how much and for what time?
4. Are the owners ready to invest additional funds in this enterprise? If yes, how much and for what time?

Such strategic questions must be answered by the highest management body of the organization - to itself and to other management bodies, collegial and individual.

Plans for upcoming investment, or, conversely, withdrawal of capital, must be linked to the marketing strategy and the future of the business as such, taking into account the current phase of the life cycle. What changes are coming in this industry: in government regulation of this market, the likelihood of introducing or canceling protectionist measures, exchange rate fluctuations, the forecast of the situation in commodity markets, and the like - all this must be taken into account so that the financial expectations of the owners do not run counter to the realities of the market with all that it implies.