Debt Equity Ratio – Is Debt Burdening Your Financial Health?

Did You Know that the Debt Equity Ratio literally closed down numerous businesses during covid-19?

You are giving me that skeptical look.

How can a ratio close down businesses?

And what did that have to do with covid-19?

Great Questions!

But I have you covered.

However, before that, let me ask you a question.

Would You Know how to quickly find out if your business can fold over?

What I mean is a single factor that spell death knell for a business.

Am I exaggerating?

No, I am not and I shall shortly prove that.

And relax, I have done the homework for you.

So that you need not worry your head off about your business going down.

I will lay out a strong case on how to discover if your business continues to be viable in the long run.

Along the way, we will answer questions like:

• What is a good debt equity ratio?
• Debt Equity Ratio Formula
• Debt Equity Ratio Interpretation

and more...

However, let us take a step back to understand concepts related to this mysterious debt equity ratio.

Begin with Revenue

What is revenue?

This may sound like a trivial question.

Who does not know revenue you ask?

Hang on, I am going to clarify myself.

Revenue is What the Business Targets First.

It is like oxygen for the hotel or any business.

The primary goal of a business is to generate revenue.

Without revenue, a business cannot survive.

Revenue is an index of strength of a business.

This is because revenue generates cash flow without which a business cannot run.

Let’s dig a bit deeper now.

What If Revenue Decreases or Worse Runs Dry?

Remember we said revenue is like oxygen.

Well, can you imagine a situation where the oxygen in the air disappears.

You will stop breathing!

The same thing happens when revenue dries up.

Your business will stop breathing (aka stop running).

Why is that, you are curious to know?

Indeed, I am coming to that.

Remember another thing we said earlier.

Revenue generates cash flow.

In other words, earning revenue creates cash resources with which the business can run.

Revenue stops, cash flow will also stop.

And so will the business.

It is not that if revenue stops or decreases for a day, the business will stop running.

However, sustained revenue decrease will lead to that.

This is what happened during covid-19.

Let me explain.

The Covid-19 Revenue Crunch

The hospitality business model is a unique one.

It is seasonal to begin with, meaning business volumes differ from month to month.

Hotels strive to keep the revenue graphs on an upward trend as much as possible.

This is while they are battling the phenomenon of fixed costs.

A hotel goes through annual cycles of high, low and moderate volumes of monthly business.

Occupancies are barometers of hotel business volumes.

A hotel can reach occupancies of above 90% (and a full house too on select days) in peak months.

Low months however are huge challenges for the hotel business.

With occupancies dipping below the 40% mark, revenue shrinks.

An ongoing hotel strategy is to drum up extra volume (at high commission costs often) during low months.

So that the overall revenue graph does not dip!

However, occupancies and revenue are part of only one side of the picture.

Hotels have also to deal with the other insidious enemy - fixed costs.

These are costs which do not change with business volume.

Meaning, these costs will remain the same whether you are running 30% of 90% occupancy.

Fixed costs turn into an advantage during high occupancy months.

Because they are covered many times over by substantially high revenue.

However, they depress revenue (and bottom line as well) in months of low occupancies.

How Revenue Drop Affects Owner Equity

So, this see-saw battle of high and low month occupancies goes on in the hotel business regularly.

This seasonality factor makes sustenance in revenue consistently over time a major hurdle.

One that needs to be crossed on a daily basis.

It is critical to understand that we are talking only about low occupancy months.

This could mean anything from 40% to say 50% and their effect.

At 40% occupancy, the hotel still runs and revenue is earned.

Imagine a worst case scenario where there are no customers coming to the hotel!

In other words, occupancy is at zero or close to it.

• Imagine employees ready to serve customers who just aren't there.
• Imagine hotel restaurants having prepared food menu items but no one to serve.

A colossal wastage of resources would happen.

Worse, the hotel business would be devastated if this situation continued for a month or more.

But this is exactly what eventually happened when the covid-19 pandemic struck.

And carried on for two years at the least.

Hospitality businesses thrive on volumes.

These busy establishments underwent the mind numbing reality of absence of customers.

This is a business model shift nobody wants to confront.

It strikes at that very sustenance we talked about which is a foundation of the business model.

In this scenario, let us now understand what the debt equity ratio is all about.

The Debt Equity Ratio Paradigm

Take a look at the infographic below.

Pay attention to the second ratio in the below infographic.

Now let us learn what a Debt Equity Ratio is.

This Blog Post will cover:

What is a Solvency Ratio?

Take another look at the infographic above on Solvency Ratios.

Solvency Ratios are indicators of the long term health of a business.

They give you hints at the sustainability of a business.

You saw in earlier posts in this series about liquidity ratios.

Liquidity Ratios are indicators of the short term health of a business.

In the same way, Solvency Ratios play the role for the long term.

That most times will mean relating to assets, liabilities and owner equity.

One of the most powerful solvency ratios for a business is the Debt Equity Ratio.

Let’s see what it is about.

Debt Equity Ratio

We learned about revenue earlier.

However, what is Debt Equity Ratio?

Let me use a metaphor for this.

Assume you are a student who has taken a loan for your undergraduate course.

Why did you take a loan?

Because you did not have “enough money of your own.”

You continue to do internships, temporary jobs so that you can pay your loan even as you study.

Suddenly, in a certain month you are not able to pay the loan installment.

And another month and more.

Your institution warns you about the penalty for continuous non-payment.

It is inevitable that you are in danger of forfeiting your studies.

Your loan is a central part of your education.

It is an obligation you must fulfill.

Without it, your studies cannot continue.

Now let us relate that to the Debt Equity Ratio.

The Student Loan in the metaphor is the debt for a business.

Debt actually means long term borrowing (like your student loan).

Equity on. the other hand can loosely be called “own money.”

It is how much money you can call your own.

Businesses run their operation mostly due to two major financing methods:

• Equity (own money - will explain this more shortly) and
• Debt (borrowing - money borrowed from a third party)

Now the Debt Equity Ratio is similar to the student loan and own money.

It measures by comparing:

• How much a business has borrowed
• Versus how much own money the business has

This is a measurement of the long term capability to meet obligations.

That capability comes from earning revenue.

Revenue builds owner equity (through profit).

On the other hand, your Long Term Obligations are commonly known as Long Term Liabilities.

Liabilities can be long and short term.

Take a look below at the Long Term Liabilities of Paradise Hotel.

Now you realize why we needed to know about revenue and long term liabilities before knowing debt equity ratio.

Debt Equity Ratio compares long term capability with long term obligations.

Or in other words, equity with debt.

We will see soon why as a hotel senior manager you must know what this Debt Equity ratio is about.

Debt Equity Ratio measures the extent of borrowing versus own money.

See the full Paradise Hotel Balance Sheet below.

The lower part of the section in green relates to long term liabilities or debt.

The blue section relates to owner equity.

Debt Equity Ratio measures debt to owner equity.

Higher the Debt Equity Ratio, the riskier will be its capability to meet obligations.

In other words, lower the ratio, the better the solvency.

Hotel Owners prefer a lower ratio since this means better chances of sustainability.

It of course means balancing capability (own money - equity) with obligations (borrowing - debt).

Hotel Management needs to balance:

• healthy owner equity situation with
• moderate debt.

Debt Equity Ratio Formula

Debt Equity Ratio is simply the ratio of Debt and Owner Equity.

The formula is:

Debt DIVIDED BY Equity (Owner Equity)

In the above formula, Debt is defined as Long Term Borrowings (payable over more than one financial year).

Equity (known as Owner Equity) is defined what the business can call its own money.

Owner Equity is built up by profit.

Profit can only be achieved with better revenue generation.

Want to Learn More on How Profit Builds Assets & Owner Equity - Click the Ribbon at the Top of this Page for a Free 7 Step Visual Guide. 

Now, take another look at the Owner Equity of Paradise Hotel above.

Let us explain what debt and owner equity shown are.

We will begin with Debt, also known as long term borrowing:

• Mortgage Payable - these are long term loan or borrowings from lenders known as debt
• Deferred Income Taxes - these are liabilities for any long term tax amount due.

Owner Equity on the other hand includes:

• Paid Up Capital - these are subscriptions paid by the public as investors
• Retained Earnings - these are accumulated profit of the hotel.

When the hotel makes a profit, Retained Earnings go up.

In a way you could say you are measuring the extent of solvency Vs obligations.

Let us now see the example with numbers using the Paradise Hotel Balance Sheet shown above.

Debt Equity Ratio Example

The Long Term Debt and Equity for Paradise Hotel as of 12.31.2018 & 12.31.2019 are:

• Mortgage Payable (Debt): 2018 - $410,000 2019 - $400,000
• Owner Equity (Equity): 2018 - $420,000 2019 - $517,300

The Debt Equity Ratio for Paradise Hotel as of 12.31.2018 is:

Long Term Debt DIVIDED BY Owner Equity OR

$410,000 Divided by $420,000 = 0.98

Debt Equity Ratio of 0.98 is an alarming ratio.

We will see why shortly.

And as of 12.31.2019 is:

$400,000 Divided by $517,300 = 0.77

What is a Good Debt Equity Ratio?

An ideal ratio of debt to equity in any business is considered to be 2.

Often a good debt equity ratio tends to be between 1 and 1.5.

If it is 2, debt is twice that of equity.

Or in other words, debt is 66% and equity 34%.

For the hotel industry, the general consensus is that debt must NOT be higher than 65%.

This is approximately the same as 66% we saw earlier.

Let us relate this to the Paradise Hotel.

Notice how the Debt Equity Ratio improves from 0.98 on 12.31.2018 to $0.77 on 12.31.2019.

Why do I say improvement?

Because the ideal ratio should be 65% for debt.

As of 12.31.2018, it is at an alarming 98%.

This means debt is almost equal to equity when it should be maximum 65%.

But this ratio improves in 12.31.2019 to 77%.

Notice that this improvement is contributed by both higher owner equity and lower debt.

However, the debt equity ratio is still way above the 65% recommended.

You will see in the next section how knowing the debt equity ratio is critical for a business.

Debt Equity Ratio is thus a barometer of the balance between borrowings and own money.

The indication on 12.31.2019 is that the debt equity ratio improves.

However, the ratio is still far from being healthy.

Let us now see how it is useful to calculate debt equity ratio.

More importantly, how you can avoid some alarming situations shown below.

How is Debt Equity Ratio useful?

For Paradise Hotel, you found the that Debt Equity Ratio on 12.31.2018 is 0.98.

This is a highly unhealthy ratio.

What does “unhealthy” mean?

Unhealthy means that say, Paradise Hotel suffered a sustained decrease in its revenue.

This would mean that the owner equity would not improve.

Remember that revenue through profit improves owner equity.

Owner equity improves when a business earns good revenue as well retains strong profit.

If revenue decreases, the retained earnings in the owner equity would not increase (improve).

Retained Earnings are accumulated profit of a business.

Considering that debt is 98% of owner equity, this is dangerous.

There is a risk that Paradise Hotel may default in its loan payments.

This can mean danger to the survival of the business itself.

However, ratio of 0.77 on 12.31.2019 tells you that Paradise Hotel improved its retained earnings.

This has meant better owner equity.

In other words, dependence on borrowing or debt has decreased (though not entirely out of danger).

If you remember, we said that lower the ratio the better the solvency.

Debt Equity Ratio is one of the best indicators of solvency.

Solvency is one of the key measures of long term sustainability.

In other words, the ability to pay long term liabilities with long term assets.

Is the hotel able to cover its long term liabilities with its owner equity?

Or, how solvent is the hotel?

So, they are able to provide the cash necessary to pay long term debt.

This is the reason the Debt Equity Ratio is critical.

Reasons Your Hotel Debt Equity Ratio May Become Alarming

What are some reasons you could avoid being in a situation of high debt equity ratio?

First, manage your revenue well.

Revenue is the foremost priority for a business.

It leads to improved profit (if expenses are managed well) and is critical for liquidity.

While they boost liquidity, it also helps in solvency.

Second, manage your debt or borrowings, which are simply long term liabilities.

In the case of Paradise Hotel, as of 12.31.2019, the hotel managed its owner equity better.

Debt is not causing as much pressure on owner equity as in the earlier year.

However, they are not out of the woods yet.

Third, balance your revenue with your expenses.

This will lead to better profit.

Profit will build retained earnings which will improve owner equity.

Improved owner equity will reduce pressure of long term debt on the business.

In the case of Paradise Hotel, it did just that on 12.31.2019.

As said earlier, it is an improvement not the achievement of the ideal situation.

Further you must ensure that you do not fall prey to some traps stated below.

Traps You Must Avoid with Debt Equity Ratio

As we have said earlier, financial ratios are mere indicators.

It is critical that we understand how they are calculated.

Debt and Owner Equity play a part in this ratio.

So, both revenue and profit must be taken into account.

Similarly, movement in long term debt must also be considered.

These movements have to be monitored each month and year.

You must therefore keep an eye on the overall long term borrowing and owner equity closely.

This is to ensure they do not spiral out of control.

Big Picture of Hotel Debt Equity Ratio

At the end of the day, you must step back and take a big picture overview of solvency.

Meaning, look at the solvency picture in entirety.

And not just look at revenue or profit on the one hand and long term debt on the other in isolation.

The big picture will be how solvent the business is.

This means a healthy Debt Equity Ratio.

That will allow you to run your hotel operation without any sustainability doubts.

Chapters in this Ultimate Guide on Hotel Financial Ratios

This Ultimate Guide is a twelve part series which will cover the following key areas:

• CHAPTER 1 of 12 - Hotel Financial Ratios - Why should you care? [Already Published]
• CHAPTER 2 of 12 -Liquidity Ratios Intro - Acid Test Ratio [Already Published]
• CHAPTER 3 of 12 -Liquidity Ratios - Accounts Receivable Turnover Ratio [Already published]
• CHAPTER 4 of 12 -Liquidity Ratios - Working Capital [Already Published]
• CHAPTER 5 of 12 -Solvency Ratios - Net Worth [Already Published]
• CHAPTER 6 of 12 -Solvency Ratios - Debt Equity Ratio [This Post]
• CHAPTER 7 of 12 -Activity Ratios - Inventory Turnover Ratio
• CHAPTER 8 of 12 - Profitability Ratios Intro - Gross Operating Profit
• CHAPTER 9 of 12 - Profitability Ratios - Return on Investment Ratio
• CHAPTER 10 of 12 - Profitability Ratios - Return on Equity Ratio
• CHAPTER 11 of 12 - Asset Management Ratios Intro - Asset Turnover Ratio, RevPAR
• CHAPTER 12 of 12 - How to Identify Warning Signs in Hotel Financial Ratios

Next Week

We will dive into the seventh of hotel financial ratios - Interest Coverage Ratio

We will see:

• What interest is and how it is related to debt?
• Meaning of Interest Coverage Ratio?
• Why is Interest Coverage Ratio considered so critical? (With a Covid-19 illustration)
• How do you read and use interest coverage ratio?

and more…

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