What is Debt to Equity Ratio?
Debt to Equity Ratio, also called the gearing ratio, denotes how much debt a company uses relative to its equity. Debt to Equity Ratio signifies the proportion of the shareholder’s equity and the debt used to finance the firm’s assets.
You must check the company’s debt on its balance sheet before investing in its shares. It helps determine the company’s financial leverage. You get an idea of how much debt a company bears to finance its projects and expand the business.
The average Debt to Equity Ratio varies across industries. For instance, manufacturing companies tend to have relatively higher debt, whereas technology firms have lower debt on their balance sheets.
Capital Structure is a combination of debt and equity to finance a company’s operations. The Debt to Equity Ratio shows how a firm’s capital structure is tilted toward debt or equity.
Debt to Equity Ratio Formula:
Debt to Equity Ratio = Total Liabilities / Shareholders Equity
You may use an alternate calculation considering long-term debt instead of a company’s total debt. However, this is called the long-term debt to equity ratio.
Debt to Equity Ratio Calculations:
Suppose a Company XYZ Ltd. has total liabilities of Rs 3,000 crore. It has shareholders equity of Rs 15,000 crore. Using the Debt to Equity Ratio formula, you get:
Debt to Equity Ratio = 3,000 / 15,000 = 0.2.
Let’s have another example: Company ABC Ltd. has total liabilities of Rs 500 crore. It has shareholders equity of Rs 300 crore. Using the Debt to Equity Ratio formula, you get:
Debt to Equity Ratio = 500 / 300 = 1.66
Suppose the company increases the total debt by Rs 200 crore by taking a business loan. The new total debt is Rs 700 crore, and the shareholder’s equity remains at Rs 300 crore. Your Debt to Equity Ratio increases to 2.33.
The Debt to Equity Ratio tells you how much debt the company bears per Re 1 of Shareholders Equity.
What is the significance of the Debt to Equity Ratio?
- The Debt to Equity Ratio helps you check a company’s financial health. You can also determine the company’s liquidity through this ratio.
- You can understand if a company has high or low debt on its balance sheet. High debt may impact a company’s profitability and thereby its ability to issue dividends to its shareholders.
- The Debt to Equity Ratio helps creditors determine if they should sanction loans to businesses.
- A higher Debt to Equity Ratio may signify that a company poses significant risks to shareholders. It increases the chances of bankruptcy if the company’s profits go down.
- A lower Debt to Equity Ratio signifies that a company focuses on a lower amount of debt to finance the business than equity financing. You could consider investing in shares of companies with a Debt to Equity Ratio of around 1.0 to 2.0.
- Finally, Debt to Equity Ratio depends on the industry. It helps to select companies with Debt to Equity Ratios below 2.
Sometimes businesses have a negative Debt to Equity Ratio. It is because the company has a negative Shareholders’ Equity. Shareholder’s Equity is Assets minus Liabilities.
If liabilities are higher than assets, then shareholders’ equity is negative. Lenders and investors consider negative Debt to Equity Ratio as risky. It may indicate that the business may get bankrupt after some time.
Is there a direct connection between Debt to Equity Ratio and Return on Equity (ROE)?
Yes, there is a direct connection between Debt to Equity Ratio and ROE. For instance, if a company uses borrowed capital well, then a higher Debt to Equity ratio may lead to a higher ROE.
Lets understand this concept with an example:
Particulars | Company X | Company Y |
Total Assets | Rs 2,00,000 | Rs 2,00,000 |
Return on Assets (ROA) | 12% | 12% |
Total Debt | Rs 80,000 | Rs 90,000 |
Rate of Interest Payable on Debt | 7% | 7% |
Leverage | 2.50% | 3% |
Return on Equity | 20% | 24% |
Both companies X and Y have the same assets and same return on assets. However, Company Y has a higher debt than Company X. Also, Company Y has a higher return on equity than Company X. It shows that Company Y has utilised debt well to generate a higher ROE.
What are the limitations of Debt to Equity Ratio?
- If a company has a high Debt to Equity ratio, the cost of borrowing goes exceptionally high. The company may struggle to service its interest obligations which could drive down its share price.
- The Debt to Equity ratio has many variations. You could struggle to compare the performance of two companies without adjusting their Debt to Equity ratio.
- The Debt to Equity ratio may not be effective for companies with volatile share prices.
Conclusion:
- A low Debt To Equity Ratio may signify a mature firm which has accumulated lots of money over time.
- However, it may mean that a company is not utilising its resources optimally.
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