Download Debt Equity Ratio - Sa-Dhan

Sa-Dhan Microfinance Manager Series: Technical Note # 21
{ What is Debt Equity Ratio? How to use it in Microfinance? |*
S
a
–
D
h
a
n
What is Debt Equity Ratio or DER?
The debt-to-equity ratio indicates the relationship of debt to equity financing.
This Ratio expresses the relationship between capital contributed by creditors
and that contributed by owners. It expresses the degree of protection provided
by the owners for the creditors.
The higher the Ratio, the greater the risk being assumed by creditors. A lower
Ratio generally indicates greater long-term financial safety. Creditors generally
prefer a low DER, since this provides a large cushion of protection. Also,
a Microfinance Institution (MFI) with a low DER usually has greater flexibility to
borrow in the future. A more highly leveraged MFI has a more limited debt capacity.
What is the formula for Debt Equity Ratio?
Total Liabilities
Total Equity
What does it measure?
DER is the simplest and best known measure of capital adequacy as it measures
the overall leverage of the institution.
This Ratio is of particular interest to lenders because it indicates how much of
a safety cushion (in the from of equity) there is in the institution to absorb losses.
Traditionally, MFIs have had low debt to equity ratios, because as NGOs their
ability to borrow from commercial lenders was limited. As MFIs reconstitute
themselves as regulated intermediaries, however, DER will perhaps rise rapidly.
Risk and volatility (whether the MFI is likely to be exposed to strong shifts in
the business environment, for instance), determine how much debt can be carried
for a given amount of equity.
Even the most highly leveraged MFIs carry less debt than conventional banks would,
because their loan portfolios are backed by less collateral and their risk profiles
are still not as well understood as those of conventional banks.
However, highly leveraged (see Box and next page for leverage and related aspects)
MFIs (those with heavy debt in relation to equity), are more vulnerable to business
downturns than those with lower debt to equity positions. Most of the large
cooperative MFIs in India have tapped clientele capital to a very significant extent
and hence, they would have debt-equity ratios attractive from a creditor's
viewpoint.
What is the concept of Leverage and Impact on DER?
Leverage refers to the extent to which an MFI borrows money relative to its amount
of equity.
In other words, it answers the questions of how many additional units of currency
can be mobilised from commercial sources for every unit of currency owned by the MFI.
Leverage states the relationship of funding assets with debt versus equity. The degree
of leverage greatly affects the return on equity ratio of an MFI (see below)
EFFECT OF LEVERAGE ON DEBT EQUITY RATIO
MFI 1
MFI 2
Average assets
400,000
400,000
Average liabilities
200,000
300,000
Average equity
200,000
100,000
Net income
20,000
20,000
10%
20%
Debt Equity Ratio
An MFI that is more highly leveraged than another MFI, will have a higher return on equity,
all other things being equal. When an MFI is regulated, the degree to which it is allowed
to leverage its equity is based on capital adequacy standards.
It is important for all organisations to maintain a proper balance between debt and equity.
If an MFI has a large amount of equity and very little debt, it is likely to limit its incomegenerating potential by not making use of external sources of debt (that is, a line of credit
or a loan that can be borrowed for, say, 10% and lent to clients at 24%). Therefore, it may
be better for the MFI to increase its liabilities, if possible, to increase its income-generating
assets (its loan portfolio).
Note, however that this only considers financing costs, not operating costs or loan
loss provisions.
In this example, if the operating costs and loan loss provisions as a percentage of loans
outstanding are greater the 14% – the spread – then the MFI should not borrow.
An organisation must ensure that it does not take on too much debt relative to its viability
to repay that debt.
S
a
–
D
h1
a2
3
n
How to interpret the Ratio?
Changes in the Ratio are often more important that the absolute level of
that indicator.
If DER increases rapidly, the MFI may be approaching its borrowing limits, which
in turn will force it to curtail growth.
Also, rapid increases in debt funding are bound to put pressure on an MFI's margins.
The terms on which an MFI borrows also influences how much debt it can
safely carry.
What minimum records are required for calculating the Ratio?
Key financial statements like the Balance Sheet and Income Statement,
appropriately constructed and adjusted for loan losses, depreciation, accrued
interest, inflation impact, subsidies etc.
Share ledgers and loan repayment ledgers with regard to borrowings.
What events/activities affect (distort) the Ratio?
This ratio is affected by unaccounted, unreported and/or hidden subsidies with
regard to operations.
How to calculate the Ratio?
Sum all the liabilities from the Adjusted Balance Sheet this is the numerator of the Ratio.
Step
Sum up all the equity accounts from the adjusted Balance Sheet – this is the denominator.
Step
Step
Then, divide the Sum of Liabilities by Sum of Equity to the value of the Debt Equity Ratio.
BOX – DISTINCTION BETWEEN DEBT AND EQUITY
The principal distinctions between these two main financing means are
EQUITY
DEBT
Normally retained, except when the
venture is dissolved or liquidated (no
maturity date).
Always repaid according to schedule
described in the loan agreement (stated
maturity date or retirement within specific
time frames.)
Project needs can be entirely (100%)
financed.
Project needs cannot be fully financed by
debt or by equity.
Profit distribution to owner (i.e. dividends)
is not a legal obligation.
Interest payment on a debt is a legal
obligation that has to be met on time.
Dividend distribution is decided upon by
board of directors at year-end in light of
the cashflow earned, the need to finance an
expansion programme or replace assets,
and the expectation of share holders.
Interest rates on debts are
predetermined and agreed before hand
by the two parties.
Dividends can be increased, decreased or
withheld.
Interest rates are fixed, or the calculation
method to be applied is agreed upon
before debt is obtained.
Dividends are redistributed from net
profits after taxes have been paid.
Interest payments are deductible from
revenue and thus reduce the tax liabilities.
Owners get all the benefits (or penalties)
if the project succeeds (or fails).
Lenders get nothing more than the
interest.
Owners are informed about the firm's
performance in the annual report of its
board of directors.
Lenders closely monitor the firm's financial
situation to ensure compliance with the
provisions of the loan agreement.
In case of bankruptcy, owners are last in
line for repayment.
Debt takes precedence over equity for
purposes of reimbursement of the loan
amount and interest payments.
Higher risk category.
Safer than equity.
*This technical note has been compiled specially for Sa-Dhan by Ramesh S. Arunachalam, using Best Practices material available with Sa-Dhan and stakeholders like
CGAP, SEEP and others. First published in August 2006. © Sa-Dhan. Website : www.sa-dhan.org