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What is Debt-to-Equity (D/E) Ratio? – Formula, Benefits & Calculation?
14 October 2022
Before investing in any particular company’s share, one must study several parameters. The liabilities and equity capital of a company are two of the necessary elements one should gauge. The debt to equity ratio does just that; it helps you understand how much debt and equity a company uses. This helps investors assess the concerned company’s reliance on debt.
This blog takes you through debts to equity ratio, its formula, interpretations, pros and cons and the ideal ratio to consider while investing.
What is the Meaning of Debt and Equity ?
To understand the debt to equity ratio, let’s first understand the terms- equity and debt:
Equity is the net worth of the company. It is the value that shareholders would receive after a company liquidates its assets and pays off its liabilities. Equity is the permanent capital an owner or shareholder holds at the end.
Equity is classified into book value and market value. Book value of equity is calculated as the difference between assets and liabilities and entered into the company’s balance sheets. Market value is an estimation of the current share prices.
Unlike equity, debt refers to the capital or funds that a company owes to others. These are obligations for a business to meet within a given time. A business has to pay off its debt along with interests against the amount.
Debt is of three types: term loans, debentures and bonds. Term loans are taken from banks while bonds and debentures are issued to the general public.
The debt value is subtracted from a company’s asset value to understand its net worth. These two factors are beneficial in judging an organisation’s financial performance. To make the understanding convenient, equity and debt are represented in ratios like 1:1, 1:2, 2:1, 2:2 etc.The debt to equity ratiogives an idea to investors whether a company easily meets its debt obligations or is on its way to bankruptcy.
How to Read the Debt to Equity Ratio?
One can find the debt to equity (D/E) ratio on the company’s balance sheet.
The debt to equity ratio of any company is shown as-
D/E Ratio = Total debt of a company / Shareholders’ equity.
Let’s assume that Company A’s debt to equity ratio is 1:2. This implies that the debt the company owes to banks or other organisations (numerator) is less than its total equity (denominator).
One would expect the ideal debt/equity ratio to be 1:1, showing stable financial functioning. However, there may be changes in the ratio due to the volatile nature of the market. Many analysts consider a DE ratio of 2:1 to be ideal, but this can vary across industries.
How to Calculate the Debt to Equity Ratio?
The DE ratio formula is given below:
Debt to equity ratio = Total debt of the company / shareholders’ equity
Total debt = short term borrowings + long term borrowings + fixed payment obligations
Shareholders’ equity is the net assets a company owns.
Total liabilities of Company A are Rs. 60 crore while its total shareholders’ equity is Rs.30 crore.
The debt to equity ratio of Company A stands to be (60 crore / 30 crore) 2:1
This means the company has more debts to pay than its net assets.
When a company’s debt to capital is above 1 (ratios 2:1 and above), it is a high D/E ratio. A high DE ratio can be good and harmful for a company.
Here are a few benefits of a high D/E ratio:
A business can receive a high Return on Equity (ROE) as its assets increase and its equities decrease.
When the cost of debt is lower than the cost of equity, a higher debt ratio can be beneficial. This lowers the weighted average cost of capital (WACC).
Owners can retain control, and the company can leverage the increased cash flow to increase its returns.
Drawbacks of a High Debt to Equity Ratio
Having a high DE ratio can also be a setback to a company. Below are some of these disadvantages:
A high D/E ratio results in a higher risk factor for investors who may have second thoughts about investing their hard-earned money.
The owner has to be careful before borrowing more funds as a high DE ratio means delayed repayments.
When the WACC of a company goes extremely high, its share prices tend to drop.
How to Interpret the Debt to Equity Ratio?
The following is an interpretation of different DE ratios:
When the ratio is 1:1, the company has a stable flow of equity and debts. Here, its liabilities are timely met, and there is no shortage of assets
When this ratio stands less than 1 (1:2, 1:5 etc.), the company has few debts. These are manageable with ample net assets present
The DE ratio of 2 and above is considered a too high number. Here, the debt is more than assets. If not timely met, it can lead a company to bankruptcy
What is a Good Debt to Equity Ratio?
In simple terms, a debt the company can easily pay is “good” debt. Numerically, ratios below 1 are good debt-equity ratios.
Shares of companies with good D/E ratios are favourable for investors. They have a lesser risk of going down soon than the companies with bad D/E ratios.
What Is a Bad Debt to Equity Ratio?
When a company cannot meet its interest and debt payments for various reasons like a drop in sales or fewer workforces, its D/E ratio rises.
Debt to equity ratio of 2 or above is considered a bad D/E ratio. Such companies carry high risks for investors. Although share prices of these companies are usually low, they have a looming fear of bankruptcy.
DE ratios between 5 and 7 are a very high-risk zone for companies.
What is Long-Term Debt to Equity Ratio?
The long-term debt to equity ratio dictates the leverage of a company. To calculate this ratio, one has to divide a company’s long-term liabilities by its equity.
The company’s leverage is directly proportional to its long-term D/E ratio. Companies with higher long-term D/E are risky investments. Yet, they can generate more growth.
Long-term D/E ratios are not ideal for short-term investors to consider.
A company needs to have manageable levels of debt and equity. Those that borrow innumerable debts might fall short of assets to pay them up. There is no doubt that a slightly high debt to equity ratio has some benefits. However, if it gets too huge, paying debts in time can be a challenge.
For an investor, a high DE ratio is an opportunity only when they are willing to invest long-term. Those who are new to the trading game will want to make a well-researched decision before investing.
FAQs on Debt to Equity Ratio
Q1. How do dividends affect the debt to equity ratio?
Ans. The D/E ratio of a company decreases when shareholders receive their dividends. Though dividends are not a part of equity, paying cash to shareholders reduces their equity as a company pays them from its earnings.
Q2. What is the ideal DE ratio?
Ans. The ideal debt to equity ratio depends on the industry and a company’s repayment capacity. Many analysts consider a DE ratio of 2:1 to be ideal as it is manageable. For other industries, this can vary from 2 to 2.5.
Q3. Why is the debt to equity ratio important to investors?
Ans. The D/E ratio reflects the financial health of any company. A high D/E ratio implies that the company has high levels of debt. If not taken care of, the company may go bankrupt. Investing in such companies can be a risk of losing money to investors.
Q4. What does a negative debt to equity ratio mean?
Ans. When a company has more liabilities than assets, its D/E ratio is negative. These companies carry a high risk of bankruptcy, resulting in most investors avoiding them.
Q5. What is the formula for the long-term debt-capital ratio?
Ans. The formula of calculating long-term debt-to-capital ratio is: Long-term D/E ratio = Long-term debt / Shareholders’ equity.
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Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information, and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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