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Debt to equity ratio is a capital structure ratio which evaluates the long-term financial stability of business using balance sheet data. It is expressed in term of long-term debt and equity. Debt to equity ratio can be viewed from different angles such as of investors, creditors, management, government etc. Therefore, the meaning and interpretation of this financial ratio vary with the objective with which it is looked at.
Debt equity ratio, a renowned ratio in the financial markets, is defined as a ratio of debts to equity. It is often calculated to have an idea about the long term financial solvency of a business. A business is said to be financially solvent till it is able to honour its obligations viz. interest payments, daily expenses, salaries, taxes, loan instalments etc.
How to calculate debt to equity ratio?
Debt equity ratio is calculated using debts and shareholder’s capital. The formula of debt to equity ratio is as follows:
Debt to Equity Ratio
Shareholder’ Equity + Reserves and surplus + Retained Profits – Fictitious Assets – Accumulated Losses
At the first sight, the formula looks quite simple and easy to calculate but it is not all that easy. It requires a good understanding of the terms viz. debt and equity. Both debt and equity is not a single item on a balance sheet but they are a broad category of which there are many items. We have to ascertain the nature of different components of the balance sheet to decide their inclusion in the category.
In the calculation of the ratio, debt is defined as the outside liabilities. As per the definition, the debt would include debentures, current liabilities, and loans from banks and financial institutions.
The inclusion of current liability is controversial because debt to equity ratio is all about long-term financial solvency and current liability is a short term liability and the amount of current liability fluctuates far and wide over the year. Further, current liabilities are taken care of in liquidity ratios (such as current ratio and quick ratio) and the interest on them is not so huge. The other side of the coin demonstrates that, after all, the liability is an outside liability and holds similar preferential rights of getting paid just like long term debts in the event of liquidation. It is agreed that a number of current liabilities fluctuate in a year which is true when looked at single items in the whole category but a fixed portion of current liabilities always stays on the balance sheet.
Considering the explanation, we assume that the current liabilities should be a part of the calculation of debts in debt to equity ratio.
Equity, for the purpose of calculating debt equity ratio, should include equity shares, reserves and surplus, retained profit, and subtract fictitious assets and accumulated losses.
Interpretation of Debt to Equity Ratio
The ratio suggests the claims of creditors and owners over the assets of the company. Suppose the ratio comes to be 1:2, it says that for every 1 $ financed by debts, there are 2 $ being brought in by the equity shareholders. As we know, if the value of the assets of a company declines, it is a risk to the money of both shareholders and lenders. Since the lenders have preferential rights of payment, the risk would damage shareholders first and then reach to lenders. The ratio of 1:2, suggests that if the asset value declines by 66.67%, it will not hamper the interests of the lenders. This is called the margin of safety. If the ratio is 2:1, the margin is just of 33.33%.
The implications of debt-equity ratio would be different for the firms and the lenders.
D/E ratio for the firm
Limitation of higher D/E ratio / Benefits of lower D/E ratio
- If the ratio is higher, the lenders will have interference in the management as they have a higher stake in the business.
- The owner will have very fewer chances of borrowing further in the case of urgent requirements if the ratio is on a higher side but urgency can be managed well if the ratio is on the lower side.
- The Higher burden of interest will keep the profits under pressure.
Benefits of higher D/E ratio / limitations of lower D/E ratio
The benefit for the owners is that they can retain control over their business with limited capital by preferring debts over the equity. The owner can enjoy higher returns on equity because the total returns are divided into very few hands but it is only possible when the rate of return from the business is higher than the rate of interest charged by the debts. This is called “Leverage” or “Trading on Equity”.
D/E ratio for the Lenders
A higher debt-equity ratio would mean higher risk to the money. With a little stake in the business, the owners may not be very serious with business. Any problem to the business will have a higher impact on lenders compared to the equity shareholders. Here, the risk is high but the returns are limited to interest. On the other hand, at a lower D/E ratio, the lenders enjoy a better margin of safety.
It is very difficult to state a benchmark Debt to equity ratio since the usability of the ratio depends on many circumstances. Even country to country, the practically acceptable norms vary. Apart from all the above, following circumstances should also be taken into consideration:
- Type and size of the industry where the firm is operating.
- Nature of industry
- Degree of risk involved
- Whether the concerned borrower is a new or old business