Introduction:
When you apply for a loan, a lender’s checklist includes your credit history, current loans (if any), and income, all to determine your capacity to repay the loan in time. Similarly, when one decides to invest in a company, one can check whether the company has taken loans, and if yes, whether it has taken the loan in accordance with its capacity to repay. An overview of this scenario can be obtained by analyzing one of the important financial ratios, the debt-to-equity ratio. What is it, and how is it interpreted?
What Is Debt-To-Equity Ratio?
The debt-to-equity ratio, a common investment jargon, measures a company’s financial leverage. It compares total debt and financial liabilities to total shareholders’ equity. This ratio helps assess a company’s risk level—higher debt means higher risk, and vice versa.
It also helps you understand how much of the company’s financing comes from borrowing compared to investor contributions. The debt part of the ratio includes all short-term borrowings, long-term debt, and any other debt-like items listed on the company’s balance sheet.
The equity part includes funds the owners contribute (such as founders), capital raised through the market, and any retained earnings.
How To Calculate Debt-To-Equity Ratio?
One way of easily calculating the debt and equity ratio is using a financial calculator. The computation is based on the following formula-
Debt to Equity Ratio (D/E) = Total Debt ÷ Total Shareholders Equity
Here, the debt represents all the company’s liabilities, and the shareholder’s equity is the company’s net assets. The net asset is the difference between the company’s total assets and liabilities.
For instance, say this is the balance sheet of ABC Ltd.-
| Balance Sheet as of the year ending 31.03.2024 | |||||
| Liabilities and Shareholders’ Equity | Assets | ||||
| Particulars | Amount (INR) | Amount (INR) | Particulars | Amount (INR) | Amount (INR) |
| Current Liabilities | Current Assets | ||||
| Accounts Payable | 1,00,000 | Cash | 2,00,000 | ||
| Short-term Debt | 75,000 | Accounts Receivable | 1,00,000 | ||
| Total Current Liabilities | 1,75,000 | Inventory | 75,000 | ||
| Non-Current Liabilities | Total Current Assets | 3,75,000 | |||
| Long-term Debt | 3,00,000 | Non-Current Assets | |||
| Total Non-Current Liabilities | 3,00,000 | Property, Plant, and Equipment | 4,00,000 | ||
| Total Non-Current Assets | 4,00,000 | ||||
| Shareholders’ Equity | |||||
| Common Stock | 3,00,000 | ||||
| Retained Earnings | 2,50,000 | ||||
| Total Shareholders’ Equity | 5,50,000 | ||||
| Total | 10,25,000 | Total | 10,25,000 | ||
Now, to calculate the ratio,
- Total Debt = 175000 + 300000 = Rs.4,75,000
- Shareholder’s Equity = Rs.5,50,000
Therefore,
Debt-to-equity ratio = 475000 / 550000 = 0.86 times
ABC Ltd. has Rs.0.86 of debt for every Re.1 of equity. This suggests the company uses more debt than equity to finance its operations, indicating a moderate level of financial leverage.
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How To Interpret Debt-To-Equity Ratio?
The debt-to-equity (DE) ratio helps you understand how a company finances its operations—whether it relies more on debt or equity.
- A high DE ratio indicates higher risk. It shows that the company uses more debt to fund its operations because it needs more equity. Simply put, it’s borrowing more to compensate for a shortfall in its finances.
- On the other hand, a low DE ratio suggests that the company has more shareholder equity than debt. This means the company doesn’t need to borrow much to fund its business. It’s operating with more of its capital, which is a positive sign for its financial health.
The high or low levels are compared with the average industry ratio because the normally acceptable debt levels differ from one sector to another. In that case, what is a good debt and equity ratio?
What Is A Good D/E Ratio?
A “good” debt-to-equity (D/E) ratio isn’t the same for every sector or company. It varies depending on the industry and the company’s specific needs. Generally, a healthy D/E ratio falls between 1 and 1.5. However higher ratios are typical for capital-heavy industries like manufacturing, finance, and mining. These sectors need big upfront investments in equipment, infrastructure, or resources. Thus, in these cases, ratios above 2 are more commonly accepted.
If a company’s ratio stays above 2 for a long time, it could signal potential financial risk. But before jumping to conclusions, you should compare the ratio to the industry and the company’s past numbers. When looking at a company’s D/E ratio, make sure to:
- Compare it to industry standards: Check competitors and the industry average to see what’s expected.
- Watch trends: Is the ratio going up or down? Big changes need closer attention.
- Consider the business stage: A fast-growing company might have a higher ratio temporarily due to expansion.
Limitations Of D/E Ratio:
Though the debt and equity ratio gives an overview of the company’s liabilities, it omits certain specifications that can be analyzed with other financial ratios. Apart from this, some other limitations of the debt-to-equity ratio include the following-
Industry Differences
Each industry has its own standard D/E ratio. For instance, capital-heavy industries like manufacturing tend to have higher ratios than e-commerce businesses. What’s acceptable in one sector could be risky in another, complicating comparisons.
Balance Sheet Timing
The D/E ratio reflects your company’s financial position at a specific moment. Changes in liabilities or equity after this snapshot might not be included. This can be especially relevant for seasonal businesses, where debt-to-equity ratios can vary based on when the balance sheet is prepared.
Quality of Debt
The D/E ratio doesn’t distinguish between different types of debt—whether short-term, long-term, high-interest, or low-interest. Some debt is riskier than others, but the ratio doesn’t capture this.
Equity Valuation
The ratio uses the book equity value, which might not match the company’s current market value. This can result in an inaccurate view of the financial leverage, especially if intangible assets with fluctuating values are involved.
Growth Stage
A company’s growth stage affects its D/E ratio. Startups might have higher ratios due to early funding needs, while more mature businesses usually have lower ratios due to steady revenue.
Profitability and Cash Flow
The D/E ratio doesn’t account for your company’s profitability or cash flow. A high D/E ratio might be okay if your cash flow is strong. It also doesn’t factor in off-balance-sheet debts, which could influence your financial situation.
Bottomline:
While the D/E ratio provides insights into a company’s financial structure, relying on it might lead to incomplete analysis. It should be interpreted alongside other financial metrics and in the industry and business stage context to get a complete picture of a company’s financial health. To better understand which metrics might work as a suitable parameter for your portfolio, you can avail yourself of share market advisory services.
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FAQ
Can a high debt-to-equity ratio be beneficial?
A high debt-to-equity ratio is beneficial because it indicates that the company can meet its debt obligations through cash flow, using leverage to boost equity returns and drive strategic growth.
What is a modified debt-to-equity ratio?
The modified debt-to-equity (D/E) ratio focuses on long-term debt by replacing total debt with only long-term debt in the formula. It’s calculated as:
Long-term D/E ratio = Long-term debt / Shareholder’s equity
This adjustment reflects the higher risk of long-term debt, which is more sensitive to interest rate changes and depends on the company’s long-term prospects. While short-term debt increases leverage, it is less risky as it must be repaid within a year.Are the debt-to-equity ratio and gearing ratio the same?
Gearing ratios measure financial leverage, with the D/E ratio being the most common. They highlight how leverage impacts a company, balancing its benefits against the risks of excessive debt.
I’m Archana R. Chettiar, an experienced content creator with
an affinity for writing on personal finance and other financial content. I
love to write on equity investing, retirement, managing money, and more.
