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Debt to Equity Ratio

What is Debt to Equity Ratio?

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. Investors, creditors, management, government etc view this ratio from their different angles influenced by their objectives. 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 honor its obligations viz. interest payments, daily expenses, salaries, taxes, loan installments etc.

How to Calculate Debt to Equity Ratio?

We need to use debts and shareholder’s capital to calculate the ratio. The formula of debt to equity ratio is as follows:

Debt Debentures + Long-term Liabilities + Short Term Liabilities
Debt to Equity Ratio = —— = ————————————————————–
Equity Shareholder’ Equity + Reserves and surplus + Retained Profits – Fictitious Assets – Accumulated Losses

At 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.

We have developed a Debt Equity Ratio Calculator for instantly calculating the ratio by plugging in the required figures in the formula.

Debts

Debt to Equity Ratio

In the calculation of the ratio, we define debt 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 short-term 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 that gets paid just like long-term debts in the event of liquidation. We all know that the amount of current liabilities fluctuate in a year. This 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

Equity, for the purpose of calculating the debt-equity ratio, should include equity shares, reserves and surplus, retained profit, and subtract fictitious assets and accumulated losses.

The inclusion of preference share is debatable because nature is similar to debt as it creates a fixed obligation. Whereas, inclusion is strengthened by the fact that it has ownership rights and does not possess the preferential right of payment like the debts have. Here again, the objective of calculating the ratio comes under the picture. If the objective is to know the financial solvency, preference capital should be included in equity whereas if the purpose is of evaluating the gearing effect of fixed dividend on the earnings, it should be a part of the debt.

Example

Assume an entity having following figures

Debentures 10000
Long-term Liabilities 15000
Short-term Liabilities 5000
Shareholder’ Equity 10000
Reserves and surplus (R&S) 25000
Retained Profits included in R&S
Fictitious Assets 500
Accumulated Losses 0

Therefore, the debt equity ratio, we will calculate as follows:

Debt Equity Ratio = (10000+15000+5000) / (10000+25000-500) = 30000/ 34500 = 0.87.

Debt Equity Ratio

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 33.33%.

The implications of the 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 a 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.

Benchmark Ratio

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, the following circumstances should also be taken into consideration:

  1. Type and size of the industry where the firm is operating.
  2. Nature of industry
  3. The degree of risk involved
  4. Whether the concerned borrower is a new or old business
Last updated on : September 2nd, 2020
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