Unlike personal debt, debt in a business environment is not always a bad thing. As I look at the debt to equity ratio, through management eyes, I need to constantly repeat this mantra to myself. This is because my experience in life has always been focused on paying down and eliminating debt, like my credit card and car loan, as this kind of debt is not helpful in any way.
Debt financing is an inexpensive source of capital compared to equity, improves the return on equity and can produce tax savings.¹ So having a very low debt to equity ratio is not always a good thing and neither is having it too high. You want it just like Goldilocks wanted her porridge – not too hot, not too cold, “just right”.
Debt to equity ratio shows how much debt a firm is using for finance relative to the total value of shareholder’s equity. So for every dollar a shareholder put in, Clarius Group received 92 cents from creditors in 2015 or another way to phrase it, would be, Clarius Group used debt financing equal to 92.2% of shareholder’s equity.
100% or 1 would indicate that equity investors and creditors have equal stakes in Clarius Group’s assets. Debt to equity ratio is an indicator of risk and a higher ratio normally shows a firm is more aggressive with debt (or potentially is a start up trying to grow rapidly). This is confusing to me as I know that Clarius Group are focused on having a low amount of financial leverage. The figure for 2015 seems to indicate they are taking on more risk and being aggressive, so I did some more research about this ratio, as I am not convinced Clarius Group are displaying these qualities.
It seems the debt to equity ratio can be calculated a number of ways and one of those ways is to exclude liabilities from the calculation that are non interest bearing². If we ignored trade payables (which the notes clearly say are non interest bearing), tax obligations and provisions then we get an extremely different result which more aligns with what I know about the Clarius Group.
Either way, shareholders of the Clarius Group own more than it owes for all four years which is a good sign. The trend of this ratio fluctuates a bit which shows that their debt management is not consistent (sometimes they need the overdraft or to sell invoices and sometimes they don’t. Also started using finance leases in 2015 which previously was not seen).
Maria also looked at the trend in profit margin to relate it to the debt to equity ratio. This is because, if you have to pay interest to external debt providers you would assume you will have less profit. This assumption does not hold for 2014. If we look at the debt to equity ratio of 66.9% (calculated in excel spreadsheet) this is an increase from 2013 but net profit margin also increased. The explanation behind this is that while liabilities rose in 2014, none of them were interest bearing liabilities.
If you look at my secondary debt to equity calculation, you can see the discrepancy falls in the year 2013 instead. Debt to equity improves to 2% but net profit margin gets worse anyway. I think this is explained by the fact that equity drops almost 50% in size in 2013 and is the denominator in the ratio calculation.
For a firm like Clarius Group that has a volatile revenue stream (dependent on economic activity and cyclical business environment) or has a large portion of business tied up in just a few customers (40% of revenue from just two customers) it should have a low debt to equity ratio4. Otherwise it may find a sudden loss in revenue means it cannot support all its financial obligations.
If I look at the ratio calculated with just interest bearing liabilities, I would be happy to see low risk (although this probably also means less efficiency). If I look at the ratio calculated in my excel spreadsheet I think I would be fairly concerned as the trend shows increasing risk in the business (from an investor perspective, Clarius are definitely risky to put your money into). However, at this stage, each yearly debt to equity ratio sits under 1:1 which is considered acceptable for most industries³.
- 2016, Way, J, http://smallbusiness.chron.com/advantages-using-debt-capital-structure-22011.html
- 2015, Gallo, A, https://hbr.org/2015/07/a-refresher-on-debt-to-equity-ratio
- 2015, Accounting for management, http://www.accountingformanagement.org/debt-to-equity-ratio/
- 2013, Accounting-simplified.com, http://accounting-simplified.com/financial/ratio-analysis/debt-to-equity.html