What Does A Negative Debt To Equity Ratio Mean For A Company?
Table of Contents
- 1 What Does A Negative Debt To Equity Ratio Mean For A Company?
- 1.1 Introduction to Financial Statements
- 1.2 What is Ratio Analysis?
- 1.3 What is Debt to Equity Ratio?
- 1.4 Formula for Debt to Equity Ratio
- 1.5 High Debt to Equity Ratio
- 1.6 Debt as a source of finance
- 1.7 What is Negative Debt to Equity Ratio?
- 1.8 The Dilemma with the term “negative debt to equity ratio.”
- 1.9 Can Equity of a Company can be Negative?
- 1.10 Two Perspectives on Negative Debt to Equity Ratio
- 1.10.1 The implication of a negative debt to equity ratio in terms of high debt
- 1.10.2 The implication of a negative debt to equity ratio in terms of negative equity
- 1.11 Conclusion
Introduction to Financial Statements
In this post, we will talk about “ Negative Debt To Equity Ratio”. With the numerous diverse bits of data available in any company, it was only right that we had a method of reporting or disclosing the information in a compact manner. The financial statement of a company shows the financial activities and position of a business for a stipulated period of time. However, the information shown is not just for showing sakes as they are the very things used to make the biggest decisions of the company. The information distilled in interpreted and analyzed before being used for trend analysis, comparison with other entities, and in making strategic plans for the company.
What is Ratio Analysis?
Ratio analysis is a valuation or analysis tool used to assess financial statements of public companies. It is used to make comparisons either between the financial statements of similar companies (companies in the same industry), between that of two or more accounting periods of a particular (a single) company or between company ratios and industrial ratios. It is a key analysis tool used by potential investors and other interest groups. There are several ratios used to make an analysis, but our focus is on the debt to equity ratio.
What is Debt to Equity Ratio?
Debt to equity ratio is also known as the gearing ratio or leverage ratio. It is a ratio that compares the company’s equity to its liabilities. It is as straightforward as its name: Debt represents the amount owed by any organization. That is a duty or obligation to pay money, deliver goods, or render services based on a pre-set agreement. Equity, on the other hand, is the actual value of the company. It shows the ownership interest, and it is generally the difference between the value of the assets and the value of the liabilities.
Debt to equity ratio is thus a comparison between both metrics, jointly analyzing the percentage of finance that comes from creditors as well as the percentage of finance that comes from investments. It is used to assess whether or not a company may not be able to generate enough cash in terms of its value, to satisfy its debt obligations. It shows the riskiness or otherwise of a company is in terms of its financial structure.
Also Read: DIFFERENT TYPES OF EQUITY
Formula for Debt to Equity Ratio
The ratio can be calculated using the following formula:
Debt to Equity Ratio = Total Liabilities / Equity
Total liabilities = long-term debt + short-term debt + leases
Equity = shareholder’s equity or (total assets – total liabilities)
The result is either expressed in percentage (%) or just as a number.
High Debt to Equity Ratio
A high debt to equity ratio shows that the company is financed by debts and as such is a risky company to creditors and investors and overtime a continuous or increasing debt to equity ratio would lead to bankruptcy. In general, a high debt-to-equity ratio indicates that a company may not be able to generate enough cash to satisfy its debt obligations. It is usually advised that it should not go higher than 1 as it would imply a low leverage. On the other hand, low debt-to-equity ratios may also indicate that a company is not taking advantage of the increased profits that financial leverage may come with. Anything lower than 1 means that there is a significantly larger equity base in comparison to the debt.
Debt as a source of finance
Debt as a form of finance can be more expensive than equity finance because debt finance involves regular interest payments/ debt servicing. An increasing ratio could indicate that investors are unwilling to make investments because they perceive that the company isn’t doing well. However, as regards to which is better, nothing has been suggested.
Also Read: WHAT IS EQUITY FINANCING AND HOW IT WORKS?
What is Negative Debt to Equity Ratio?
One term that has been flying around over time is “negative debt to equity ratio.” The ratio, by itself, has not been classified in terms of ‘positive’ or ‘negative’ for the very things that cause this dilemma. Here’s an overview of the challenge with the nomenclature of “negative debt to equity ratio.”
You may like to read about: WHAT IS NEGATIVE EQUITY?
The Dilemma with the term “negative debt to equity ratio.”
Off the top of one’s head, negative debt to equity ratio comes off as implying that a company is heavily leveraged and depending on debts to meet up its recurring expenses. However, this term is used off the books in this regards. This is because while it makes the layman understand that the debt of the company is significantly higher than it should be, it doesn’t actually mean that the result of the ratio was represented with a negative figure. In essence, what is regarded as a negative debt to equity ratio, is actually a ratio that is really high. A ratio of ‘4.1’ for example, is what is seen as a negative ratio and not one that shows “-40.” However, this cannot be used formally for apparent reasons.
Can Equity of a Company can be Negative?
On the other hand, if we are to assess what a negative debt to equity ratio stands for in actual terms as it is stated, we would also make a fundamental mistake because there is ideally no such thing as a negative ratio. This is because a ratio that is low means the company is relying on its available equity to meet its operation. What this then means is that a negative result would mean a negative level of equity. That is the company’s value is negative. This is a flaw that is usually avoided in accounting and economics as a company cannot have a negative value. This is because a company is only liable up to the amount Negative equity is only used in real estate and mortgages, representing the situation where the value of an asset used to secure a loan is less than the outstanding balance on loan.
Also Read: DIFFERENT TYPES OF EQUITY INSTRUMENTS?
Two Perspectives on Negative Debt to Equity Ratio
These two different perspectives mean different things for a company and they are analyzed separately below:
The implication of a negative debt to equity ratio in terms of high debt
In this regard, a negative result means that a company has more liabilities than assets. It might occur when a company uses borrowed funds to purchase an investment, and this borrowed funds actually cost higher (in terms of the interest rate charged on the borrowed funds) than the return on investment. It could also occur when adjustable rates are used to handle projects or even when there’s negative shareholders equity due to its inability to raise funds to cover historical net losses. Generally, there are many things to consider when a company is high in debt or highly leveraged. These things are represented as a high debt to equity ratio. The negative implications of too much debt include:
Reducing the ownership value:
When a company is dependent on debt to survive, it means the banks and other creditors have more stakes to the company than the actual shareholders, and if they are not careful, they stand the risk of losing the entire company to their creditors.
The company might not be able to get more financing:
Nobody wants to offer a loan to a company who apparently doesn’t have the capacity to pay back. When it has been established that a company is deep in debt, highly leveraged, or related terms, it would be harder for the company to get additional financing.
Increase in overall risk:
Generally, the risk of business increases the more it relies on debts. Things like volatility in interest rates, foreign exchange risks, and so much more. This is one major reason that debts should be taken with caution and properly planned out.
The implication of a negative debt to equity ratio in terms of negative equity
As said, negative equity shows that the value of a company is negative. Thinking of it in clear terms, equity is the difference between assets and liabilities. The difference usually signifies the amount of equity available in a company. When the result is negative, then there is said to be no value left in the company. Since a company is liable up to its value, the concept of negative equity is only valid theoretically unless it has something to do with real estate and mortgages.
The implications of negative equity include:
Dissolution of a company:
When a company is said to have negative equity, there is theoretically no value left in it. As such, it is only a matter of time until the company does not exist anymore. They would generally be required to get additional investment or be taken over by other entities.
Unattractive to investors:
Unless it is a private equity company interested in providing turnaround capital, a company with negative equity is a disaster waiting to happen. It is never advisable for anybody to invest in a company with negative equity as such, the company becomes really unattractive.
Generally, investors and the management may be comfortable with a certain level of debt to equity because it may be perceived that over time this would lead to a higher returns. However, if this doesn’t occur, it could cause a panic in the stock markets as investors would perceive that the company is doing badly and they may want to sell off their equity stake which would eventually lead to a fall in share price. Also, potential investors would not be interested in such companies and might decide not to invest in them. Moderation in both debt and equity as far as the debt to equity ratio is concerned is the best. Any other movement and the company could end up in shambles.
You may like to read about: DIFFERENCES BETWEEN DEBT INSTRUMENTS AND EQUITY INSTRUMENTS?