The debt to equity ratio is a relatively simple metric to assess the degree of leverage employed by a company. At times, however, this simplicity is a double edged sword. Here’s a simple story to illustrate one of the biggest pitfalls of this ubiquitous metric.
Doctor A bought his clinic (property) 20 years ago for $100,000. He took on no debt and paid everything from his own pocket (equity). As it is used for his medical practice, it is booked under ‘Property, Plant and Equipment’ where it is depreciated to zero over the next 20 years. Assuming there are no other assets or liabilities, and he pays all his profits as dividends such that retained earnings consistently remains at zero. Consequently, the equity of his company is always $100,000. Today, his clinic is worth $1,000,000 on the open market. Because he is a little crazy, he decides to borrow $200,000 from the bank just for the fun of it.
Doctor B is uncannily similar to Doctor A, with the exception that he is 20 years younger. Doctor B buys a clinic (property) next to Doctor A that is identical is all aspects. Unsurprisingly, Doctor B paid $1,000,000 for his clinic. However, Doctor B can’t afford to pay the full amount from his own pocket, so he borrows $200,000 from the bank.
Who has the higher debt to equity?
Doctor A has $200,000 of debt on $100,000 of equity. Doctor B on the hand has $200,000 of debt on $800,000 of equity. The answer is clear. But let’s look at the fundamentals of our 2 doctors; their properties are worth exactly the same, and let’s assume that they earn the same amount profits because they are equally skilled. They also have the same amount of debt. Fundamentally, they are exactly the same! In fact, Doctor A is sitting on unrealised property gains of $900,000 and is arguably the better off of the two.
The idea here is that debt to equity might not give an accurate picture when a company has undervalued assets on its balance sheet. These are the assets which are booked at cost and do not fairly reflect their true market value. For example, certain companies do not revalue their investment property. Property, plant and equipment is almost never revalued to market value. But when it comes to borrowing from a bank, which do you think they pay attention to – an asset’s recorded book value or its market value?