To start a business required capital for the launch products, hire employees and expand the business according to their need.
Most companies raise money in two ways through equity share or debt and these are the most common ways to raise capital.
The debt to equity ratio is the solvency ratio that indicates the ratio of debt concerning equity. This shows the relation between the part of the fund taken by creditors and the part of the fund taken by shareholders equity.
What is the Debt to Equity Ratio?
The debt to equity ratio is a leverage ratio that evaluates the amount of debt taken by the company per rupee of the shareholder's funds.
It is reflected in long term debt and equity. Having an understanding of the long-term financial well-being of the company is often countered.
The ratio brings out how the capital structure of a company tends toward either debt or equity financing. A high debt ratio means more creditors than shareholders.
In contrast to the debt to asset ratio that uses total assets as a denominator, similarly, the debt-equity ratio uses shareholders' equity.
The debt-equity ratio is an essential metric used in corporate finance and the ratio gauges ability to pay back a company its debts.
The debt-equity ratio may assist in understanding the portion of debt and equity of a company, therefore they can make reasonable determinations about vital financial strategies for their company.
How to calculate the debt to equity ratio?
While calculating the debt to equity ratio we required total debt and shareholders' equity. The debt to equity ratio is calculated by dividing the total debt by the shareholder's equity of the company.
The debt to equity ratio formula is given below:
Debt to Equity ratio = (Total Debt / Shareholders' Equity)
Although the formula looks quite simple and easy to calculate, we need a good insight into the terms that are total debt and shareholders' equity. Both debt and equity are broad items on the company's balance sheet.
What is total debt?
The total debt of a company is the sum of long term debt, short term debt and other fixed repayment obligations as well of a business under the operating cycles. The debt fund required for the operations of the company.
What is shareholders' equity?
Shareholders' equity is the company's owner's residual lawsuit on assets. After deducting the company's total debt from the total asset we get shareholders' equity.
Shareholders' equity includes share capital and reserves and surplus etc. and shareholders are the owner of the company.
Shareholders’ equity should be expressed on a book value basis. There are many ways to estimate the debt to equity ratio.
like some investors only take long term debt. But you should be consistent with one formula and do not use multiple formulae.
Some investors or analysts consider preferred stocks as debt because the company has to pay a dividend at a fixed rate like bonds.
Debt to Equity Ratio Example
Let, it is ABC company. Here is some information about ABC company.
Balance sheet for company ABC
Year ended on 31 December 2019
| Particular | Amount (Rs.) |
|---|---|
| Non-current assets | |
| Fixed assets | 425,000 |
| Long term investments | 390,000 |
| Total non-current assets | 815,000 |
| Current assets | |
| Cash in hand | 20,000 |
| Bills receivable | 50,000 |
| Inventory | 250,000 |
| Prepaid expenses | 100,000 |
| Short term loans | 200,000 |
| Total current assets | 620,000 |
| Total assets | 14,35,000 |
| Equity | |
| Share capital | 600,000 |
| Reserve | 330,000 |
| Total equity | 930,000 |
| Non-current liabilities | |
| Debentures | 200,000 |
| Long-term loans | 150,000 |
| Total non-current liabilities | 350,000 |
| Current liabilities | |
| Bills payable | 50,000 |
| Overdraft | 100,000 |
| Short-term loans | 5,000 |
| Total current liabilities | 155,000 |
| Total equity and liabilities | 14,35,000 |
Debt to equity ratio = (1,50,000+5000) / 9,30,000
Debt to equity ratio = (1,55,00/9,30,00)
Debt to equity ratio = 0.17
The debt to equity ratio is 0.17 which indicates for every rupee of company ABC owned by the shareholders, company ABC owes Rs 0.17 to creditors. The company ABC could comfortably repay the debt obligations.
Debt To Equity Ratio Interpretation
The debt to equity ratio is a capital structure ratio that indicates the amount of debt taken by the company against equity.
The debt to equity ratio evaluates how much of the total capital of the company is funded by borrowed funds and how much by owned funds.
Debt to equity ratio of 1 means that creditors and investors are on equal stakes in the company's assets.
A high debt to equity ratio is a sign of high risk. A higher ratio ( more than 1) indicates a weaker Solvency of the company that means the company doesn't comfortably pay back the long term liabilities. The company is using more borrowing funds for its operations.
In another word, a higher ratio also suggests the company is not performing well, which is why the company is taking out extra debt financing.
A lower debt to equity ratio (less than 1) reveals the healthier Solvency of the company that means the company does comfortably repay the liabilities. The company has enough equity funds and does not require debt funds for its operations. However, the company is performing well.
Investors or analysts commonly prefer a low debt-equity ratio because it would not be obligated to service much debt and any tougher time low ratio.
Always high debt to equity ratio should be avoided and as a recommendation computes the last five years debt to equity ratio, that helps to understand how a company performed in past years.
A high debt to equity ratio of the company is borrowing more than using its own money which is in shortage and a low debt to equity ratio notifies us that the company is using more of its own money compared to borrowing funds.
From this, we can conclude that a higher debt to equity ratio is troublesome for a company.
Limitations of Debt to Equity Ratio
The debt to equity ratio has also specific limitations and investors should be aware of that. Here are the limitations of the debt to equity ratio following:
1. This ratio differs from one industry to another industry and different industries have different capital needs.
Industries that require huge investments in fixed assets usually have higher debt-equity ratios because the amount needed might be too enormous for a company to raise through equity. The ratio doesn’t assist compared to inter-industry.
2. There are various varieties of the debt to equity ratio and it is heavier to distinguish without determining the ratios of the two companies.
3. The debt/equity ratio might mislead potential investors. A low debt to equity ratio can ensue in a company not funding assets with properly received debt.
Frequently Asked Questions
What is the long term debt to equity ratio?
The long term debt to equity ratio illustrates the amount of long term debt taken by the company against the equity. This ratio is just like the basic debt to equity ratio.
What is the formula of long term debt to equity ratio formula?
The long term debt to equity ratio formula is calculated by dividing the long term debt by the shareholder's equity of the company.
The formula of long term debt to equity ratio is given below:
Long term debt to equity ratio = Long term debt / Shareholders' Equity
The long term debt includes mortgages, bonds, and bank debt.
What is a good debt to equity ratio?
A good debt to equity ratio depends on the quality of the business and it varies from industry to industry.
Ideally, the debt to equity ratio should be less than 1, that is, long term debts should be lesser than shareholder's equity.
The debt to equity ratio less than 1 would be more reliable whereas a high ratio would be considered unsafe.
Generally speaking, high capital intensive sectors have a high debt to equity ratio that can be more than 2, because of purchasing more fixed assets such as plants, property etc.
similarly, less capital intensive sectors have a low debt to equity ratio such as IT sectors. For this reason, compare companies in the same sector or industry.
What does a negative debt to equity ratio mean?
A negative debt to equity ratio indicates that the company's liabilities are more than its assets. A negative debt to equity ratio also reflects that the company has a negative net worth.
Mostly, this is assumed to be a very dangerous sign, implying that the company may go bankrupt. It is not advisable to invest in a company that has a negative debt to equity ratio.
