What is the debt to equity ratio, formula & its calculation?
Choosing a company to invest in can be difficult. As an investor, you need to choose a company that will provide you with optimal returns at minimal risk. Even seasoned investors take several factors into account before picking a stock. One of those factors is ratio analysis techniques. These techniques provide you with a bird’s-eye view of the company’s financials. By gauging a company’s financial health, it will be easier for you to make an informed decision. There are several ratios available for you to choose from. One of them is the company’s debt to equity ratio. This ratio is important to investors as it shows a company’s dependency on its borrowings. It also indicates whether the capital structure is tilted toward debt or equity.
What are debt and equity?
To understand the debt to equity ratio, you first need to know what debt and equity are. Debt is the money that the company owes. When a company borrows money, the amount it needs to return is the debt. A company usually pays interest on its debt. Equity is the money the company owns. It is commonly known as shareholder’s equity. Shareholder’s equity is the owner’s investment in the company. With the debt to equity ratio, you can find out if the company’s financing depends on borrowings or equity. It also shows if the company has enough equity capital to take care of all outstanding debts. It compares the owner’s equity to the total debt the company has.
How to read the debt-equity ratio?
In the ideal world, every company should have more equity than debt. But that is not always the case. Most companies have either a high or low debt-equity ratio. Few companies have a debt-to-equity ratio of 1:1. This shows that the company’s finances are met equally by debt and equity. A ratio of less than 1 shows that a company’s finances are more by equity than through debt. A ratio greater than 1 shows the company’s financing is done more by debt rather than equity.
A company with a high debt to equity ratio has a high vulnerability, especially if a company has borrowed at a high interest-rate. Because of high debt cost, net profit will squeeze and there might not be enough funds to reinvest in the business. This might lead to bankruptcy. But not all debt-laden companies go bankrupt. Instead, some companies use their debt to invest in profitable ventures and leverage.
A company with a low debt to equity ratio shows lesser dependency on borrowings. But, it also indicates that the company misses out on leverage if they have an opportunity to raise the capital from the market at a reasonable cost.
Additional read: Ratio analysis techniques to use while picking stocks
The formula for calculating the debt to equity ratio:
Debt/equity = Total debt/ total shareholder’s equity.
Let us assume you want to find the debt to equity ratio for XYZ company. According to their financial statements, their total liabilities is ₹30 crore and their total shareholder’s equity is ₹15 crore.
Then their debt to equity ratio = 30 crore /15 crore = 2
This means that XYZ company has ₹ 2 of debt for every rupee of equity. You need to compare this with the debt to equity ratio of similar companies. You cannot compare the debt to equity ratio of two companies from different industries. One company might be in an industry where funds are needed for day-to-day operations. The other company might be from an industry where funds are not needed and they can manage on equity. We also need to look into the capex and expansion plans of the company to compare with peer group companies.
You should keep in mind that there isn’t an ideal debt-to-equity ratio. Even though most investors feel that the ratio should not be very high, you should look at the industry average for each company before deciding to invest in them. Please note that each company may have different expansion plans and capital structures to fund its capital requirements.
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