Understand Debt Ratio to analyze the company's financial health

If you are a trader looking to assess a company’s risk, the debt ratio is an indicator that should not be overlooked. This number tells you how much the company relies on borrowing to operate, compared to shareholders’ equity. By analyzing the relative level of debt, you gain a clearer picture of the company’s financial position.

Debt to Equity: Basic Meaning

Debt-to-Equity Ratio or abbreviated as D/E Ratio is a financial ratio comparing a company’s total liabilities to its shareholders’ equity. This ratio reflects how much of the company’s assets are financed through debt versus equity.

Liabilities included in the calculation are:

• Bank loans
• Bonds issued and payable
• Lease obligations
• Other financial commitments the company must settle

Shareholders’ equity refers to the residual value of assets after liabilities are deducted, including common stock, preferred stock, and retained earnings not paid out as dividends.

What Does a High Ratio Indicate?

A high debt ratio indicates that the company relies more on debt financing than equity. This situation can lead to higher short-term returns but also comes with increased risks:

• Increased interest burden: When interest rates rise, cash flow becomes tighter.
• Financial risk: During economic downturns, debt repayment may become unmanageable.
• Liquidity issues: If cash flow is insufficient or delayed, debt payments could be postponed.

Conversely, a low ratio suggests the company has less debt, with shareholders’ equity being the main source of capital, signaling a strong financial position and lower risk.

Types of Debt-to-Equity Ratios

1. Total Debt-to-Equity Ratio (

Considers all liabilities, both short-term and long-term, suitable for analyzing the overall debt burden faced by the company.

) 2. Long-term Debt-to-Equity Ratio ### Focuses solely on long-term debt, used to assess long-term financial stability and the company’s ability to meet its obligations.

How to Calculate Debt Ratio

Basic formula:

D/E Ratio = Total Liabilities ÷ Shareholders’ Equity

( Example Calculation Suppose a company has:

• Total liabilities: 50 million THB
• Shareholders’ equity: 100 million THB

D/E Ratio = 50 ÷ 100 = 0.5

This means that for every 1 unit of shareholders’ equity, the company has 0.5 units of debt. This ratio is considered relatively balanced.

Insights from the D/E Ratio

) Financial Position This ratio reveals how the company funds its operations: through debt or equity. The extent of reliance on each source indicates the company’s financing strategy.

Risk Profile

A higher ratio = higher risk, especially if the economy or interest rates change rapidly.

Capital Structure

Indicates how the company raises funds: through borrowing or issuing more shares.

Growth Capacity

If a company wants to expand significantly, a high D/E Ratio may make additional borrowing difficult. Alternatively, issuing new equity can lead to “Dilution Effect,” reducing existing shareholders’ ownership and dividends.

Advantages of Using the D/E Ratio

✅ Clear risk assessment: Since this ratio directly compares debt to equity, it clearly shows the debt burden the company carries.

✅ Benchmarking: Investors can compare ratios across companies within the same industry to evaluate which firms are less risky.

✅ Monitoring over time: An increasing D/E Ratio may signal that the company is expanding aggressively or facing difficulties.

✅ Lender evaluation: Banks and lenders use this ratio to decide whether to extend credit and at what interest rate.

Limitations of the D/E Ratio

❌ Industry differences: Different industries have varying capital structures; utilities or infrastructure companies often have higher D/E ratios than tech firms. Direct comparison may be misleading.

❌ Incomplete picture: The ratio alone doesn’t account for cash flow health, asset quality, or profitability.

❌ Potential manipulation: Companies can use accounting tricks or special financing arrangements to improve the ratio artificially.

❌ Time sensitivity: This ratio is based on a snapshot from the balance sheet date and doesn’t reflect changes throughout the year.

Application in CFD Trading

For CFD traders trading stocks, the D/E Ratio helps to:

• Assess stability: Companies with low D/E ratios tend to be less financially fragile.
• Gauge market sentiment: If the market favors companies with low debt, you might trade in that direction.
• Combine with other analyses: Use D/E Ratio alongside technical analysis, cash flow analysis, and macroeconomic trends for more informed decisions.

Summary

The debt ratio is a useful tool for understanding a company’s financial structure and risk profile. While it isn’t the sole indicator, knowing this ratio helps you make smarter investment and borrowing decisions, especially if you aim to reduce risk and plan for financial stability.