A company’s financial leverage can be calculated with the help of the debt to equity (D/E) ratio. When it comes to corporate finance, this is a very important metric and it is a degree of measurement as to which a company finances its operations with debt as compared to wholly owned funds. It is also known as risk ratio and it uses total equity as a denominator.
How can we Calculate the Debt to Equity Ratio?
The formula to calculate Debt/Equity Ratio would be,
Debt/Equity Ratio =
Total Liabilities / Shareholders’ Equity
Total Debt / Equity of Shareholders
The longer version of the formula is,
Debt/Equity Ratio =
(Fixed payment obligations + Long term debts + Short term debts) / The shareholders’ equity
To understand the formula,
The two major components present in the formula are, the total debt or liabilities and the shareholders’ equity.
The shareholders’ equity will already be stated in the balance sheet so the total debt will have to be found.
This can be done by summing up the short term and long term debts.
The shareholders’ equity consists of the net assets which are owned by the company. It is the claim that the owners of a company have over the company’s value after the debts have been relieved.
The formula for the calculation of Net Assets is Assets – Liabilities.
An example would be,
The Shareholders’ Equity is 4 crores, the long term debts is 1 crore and the short term debts are 2 crores.
To calculate the DE Ratio,
Total Debt/ Shareholders’ Equity
Shareholders’ Equity = 4 crores
Total Debt = 1 crore + 2 crores = 3 crores
So, 3 crores/ 4 crores = 0.75
How do we Interpret the Debt to Equity Ratio?
The strategy that a company utilises when it comes to financing can be understood with the help of the Debt to Equity Ratio. It allows us to analyse and figure out whether debt financing is being used or whether equity financing is being used when it comes to the operations of the business.
If a high DE ratio is received, this means that the risks are high. It basically states that the company in hand is utilising and borrowing a higher amount of funds to finance the operations due to the lack of funding. This shows that debt financing is done as there is a deficit of the company’s finances.
When there is a low DE ratio, it indicates that there is an excess of the shareholders’ equity of the company and the debts do not need to be used in financing the operations as there is a higher amount of owned capital over borrowed capital which is better for the company.
Overall, we can interpret that a higher DE ratio is harmful for the company and has a negative point of view from the side of analysts as well.
What is the Ideal Debt to Equity Ratio that a company should have?
Normally, the ideal ratio should not go over 2 as this would end up meaning that one unit of capital would be present for every two units of debt within a company. This would be very risky as it is high.
A ratio over two may be high but when it comes to manufacturing or mining industries, their average normal DE ratio is two or above, so basically it depends on which industry the DE ratio is being taken for.
This goes to show that the Debt to Equity Ratio should be compared among companies in the same industry to gain better accuracy.
What are the Benefits of Debt to Equity Ratio?
- The residual profit can be indicated as the amount of debt as compared to the level of equity can be taken and this allows us to figure out how much profit is available for holders of equity.
- The earnings of the shareholders can be understood with this ratio. Higher debt indicates higher interest that the company pays, which reduces the profits earned.
- The management can show the performance as compared to the other competition in the market and this can help make informed, improved decisions to get the ideal DE ratio which is needed.
- A higher ratio signifies a greater amount of risk and investors can decide whether or not the particular security should be invested in based on the information presented on the risk factors involved.
Are there any Limitations to the Debt to Equity Ratio?
- There are various variations in this ratio and comparing while adjusting the ratios of companies can be difficult. Increased research may be required as data or information may not easily be provided in the financial statements that are available.
- The share price or debt price may be very volatile and this may lead to a lower level of accuracy.
- The ratio cannot be used to compare across different industries as the average DE Ratio varies from industry to industry.
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