One of the most fundamental principles in the world of finance is “cut your clothes according to your cloth.” This saying emphasizes the importance of financial responsibility–spending within your means and borrowing wisely based on your repayment ability. Financial ratios can be used to quantify these principles. One of the most important ratios is the debt-to equity (DE) ratio. Learn more about the debt-to-equity ratio, its formula, and its interpretation in assessing the financial health of a company.
Understanding the Debt-to-Equity Ratio
The debt-to-equity (DE) ratio provides valuable insight into the capital structure of a company and its financial stability. It measures how much of a company’s funding comes from equity compared to debt.
Formula to calculate the Debt-to-Equity Ratio
Divide the total liabilities of a company by its equity. It can be expressed in the following way:
Ratio = Total Liabilities/Total Equity
Note that the Shareholder Equity (SE), after subtracting all liabilities, represents the residual interest of the owners in the assets of the company. It is the amount of money that would be left for shareholders after all debts are paid.
This is a formula that you need to know:
Net Assets = Liabilities – Assets
Understanding the DE ratio requires an understanding of Shareholder Equity (SE). Each shareholder becomes a part owner of a company, and their ownership stake is determined by the percentage of shares they own relative to the total number outstanding.
In the event of financial distress, equity shareholders are prioritized over creditors, including lenders and holders of debentures. Shareholders’ Equity (SE), also known as the buffer, is the ability of equity investors to cover the liabilities of the company. SE can either be positive or negative depending on the performance of a company and its financial status, making it an important metric to assess a company’s health.
Interpreting Debt to Equity Ratio
The debt-to equity ratio is a valuable tool to analyze a company’s financial strategy. The ratio can reveal whether a business relies on debt or equity to fund its operations. How to interpret the different values of the DE ratio
1. High DE Ratio
A high DE ratio indicates a greater risk profile for a company. This suggests that the company relies heavily on borrowings to fund its operation because of its insufficient financial resources. A high DE ratio indicates that the company is heavily reliant on borrowing to fund its operations due to an inadequate amount of funds.
2. Low DE Ratio
A low DE ratio, on the other hand, indicates that a company’s equity capital is significantly greater than its debt obligations. This is a positive sign for the company as it shows that they rely more on their capital than on borrowed money. Low DE ratios are often viewed as an indication of financial stability.
Industry-Specific Considerations for Debt to Equity Ratios:
The above interpretations can be used as a framework to analyze DE ratios. However, it is important to keep in mind that ideal DE ratios may vary between industries. A high DE ratio is common in capital-intensive sectors such as manufacturing. This is due to the large amount of capital required. Contrary to this, industries that are centered on services and technology might have lower capital requirements, which will result in a lower DE ratio.
When comparing DE ratios between companies, it is important to compare them with their peers in the same industry.
How to calculate the debt-to-equity ratio
You need two components to calculate the debt-to equity ratio: total debt and shareholders’ equity. Shareholder’s equity is typically found on a balance sheet of a company as a separate item. It doesn’t need any extra calculations. You will need to calculate the “total loan.”
Total debt is equal to the sum of short-term debt and long-term loans. This is a guide that shows you how to calculate DE ratios:
Step 1: Get the balance sheet for the company that you wish to analyze. Let’s look at the balance sheet for Reliance Industries Ltd. in March 2020.
Step 2: Find the relevant figures on the balance sheet.
Shareholders’ Equity (SE = Rs 4,05.322 crore)
Total debt = short-term borrowings plus long-term borrowings
Total debt = Rs (1,18,098 crore + 39,097 crore)
Total debt = Rs 1,57,195 crore
Step 3: Calculate the debt-to equity ratio using the formula.
DE Ratio = Total Debt / Shareholders’ Equity DE Ratio (rounded from 0.387 to 0.39)
The debt-to equity ratio of Reliance Industries Ltd., in this case, is around 0.39. For every unit of debt, the company has, it also has 0.39 shares of equity.
Is there an ideal debt-to-equity ratio?
It’s tempting, but it’s also important to realize that there’s no standard DE Ratio that’s universally applicable to all businesses. As a general rule, a DE ratio above two is considered to be high. This ratio suggests that the company is at substantial risk for every unit of debt it has.
It is important to note that DE Ratios vary across industries. Capital-intensive industries, like manufacturing or mining, can often have DE ratios higher than 2, while others may find it abnormal. When assessing the DE ratio, it is important to compare it with other industries and benchmarks that are specific to each sector.