What is the Debt to Equity Ratio? A Complete Guide for Beginners in Finance

What is the Debt to Equity Ratio? A Complete Guide for Beginners in Finance

When assessing a corporation’s financial condition, one of the most relied upon indicators is the Debt to Equity Ratio. This ratio is instrumental for investors, lenders, and businessmen to gauge the level of debt a company has in relation to its resources.

The purpose of this blog is to explain the Debt to Equity Ratio, its formula, importance, acceptable levels, and prudent usage of the ratio. This guide is designed for readers with some familiarity with finance, and uses simple yet precise terms that will enable them to appreciate the details of this critical ratio.

Understanding the Debt to Equity Ratio

The Debt to Equity Ratio is a financial ratio that defines the proportion of a firm's debt in relation to its equity. It shows how much a firm is using funding by way of loans compared to funds provided by shareholders. It is also used as an indicator of a company's financial risk.

In other words:

Debt to Equity Ratio = Total Debt ÷ Shareholders’ Equity

This formula shows the relationship between debt financing and equity financing for a company. If the result is high, the company is exposed to more risk. If it is low, the company is operating using its own funds.

Explaining With a Straightforward Example

Let's assume a company has taken a total debt of 10 crore rupees. The company’s total shares are valued at total equity of 5 crore rupees.

Now, substituting into the equation gives:

Debt to Equity Ratio = 10 crore ÷ 5 crore = 2

Having a result of 2 suggests that for each 1 rupee of equity, the company takes a loan of 2 rupees. This means in simple terms, the company is more reliant on loans than on capital.

Purpose of The Ratio With Other Ratios:

Debt to Equity Ratio has significant importance in regard to other fundamentals of financial equity considering its rational diversity. Each stakeholder can rely on this value to make certain decisions.

1. Assists Investors in Comprehending Risk:

“For example, a company whose Debt to Equity Ratio is too high may find it hard to stay afloat during times of economic downturns as they have to repay interest and loans on a regular basis. A low ratio is usually associated with a more financially stable company as well.”

2. Used by lenders in credit assessments:

“Usually, before granting loans, banks and other financial institutions ascertain whether or not the entity has excessive debt. Having a very high ratio might pose challenges in accessing new loans.”

3. Assists in undertaking competitive analysis:

“This ratio is widely used by investors and analysts seeking to compare and distinguish companies of relative size operating in the same industrial space and identify which ones are financially less risky.”

What Is A Good Debt To Equity Ratio?

“There can never be a specific number that every company will define as ideal. It changes depending on the industry and the business model, but here is a broad idea:”

“Anything below 1 is typically an indicator that the company is not overly reliant on debt, which is positive.”

“Still, in more capital intensive sectors such as manufacturing, real estate, or infrastructure, it is acceptable to be between 1 and 2.”

If the ratio is higher than two, it can indicate a potential issue unless the business has healthy cash flows or is operating in an industry where high loan amounts are the norm.

For instance, IT and service firms generally possess lower Debt to Equity Ratios, whereas construction and energy firms, due to their capital intensive nature, tend to have higher ratios.

How Investors Can Use Debt to Equity Ratio

For investors, the Debt to Equity Ratio is one of the first indicators to analyse when deciding whether or not to purchase a company’s stocks. It speaks to the security of the firm’s operations.

If trying to select between two firms from the same sector, the firm with a lower debt to equity ratio, even though slower, tends to be more secure. The opposite is true for the firm with a higher ratio, and while it would be more likely to take loans and thus grow faster, its risks are also much greater.

It is important to understand the balance of risk and return in this case. Some investors enjoy companies with minimal debt while others do not mind the added risk in light of good returns. In most circumstances, though, a very high ratio will present issues.

Drawbacks of Debt to Equity Ratio

Despite the advantages of the Debt to Equity Ratio, it should not be the sole number of consideration while analysing the company’s equity. Some disadvantages include:

It does not show profitability:

A company could sustain minimal operations with low profits and have low debt as well. It does not specify if the company is performing well.

It overlooks the cost of repayment and interest:

Two companies with the same ratio could have totally different risk levels depending on how costly their loans are.

The result may be influenced by accounting practices:

Some companies might be reporting debt and equity on varying bases due to differing accounting policies, which may alter the ratio.

This is the reason that using a Debt to Equity Ratio in conjunction with the Interest Coverage Ratio, Return on Equity (ROE), cash flow statements, and other financial tools is prudent.

Strategies to optimise Debt to Equity Ratio

A company can take the following steps if it wants to enhance its financial position and has a high ratio:

Repay existing loans:

Paying debts or loans reduces debt which is the quickest possible way to bring the ratio down. This enhances the financial strength of the business.

Raise more equity capital:

Equity capital can be raised/new companies can issue new shares to raise funds from the market. It increases the shareholders’ equity hence increasing the ratio.

Use profits wisely:

Retaining profits instead of spending everything as dividends provides a means of building equity while decreasing reliance on debt.

Debt to Equity Ratio vs Other Financial Ratios

Some people mix the Debt to Equity Ratio with other ratios, let’s clarify that.

It measures the equity ratio which shows how much a company’s total capital is funded by equity. This differs from the debt ratio, which only focuses on the relation of debt to equity.

Additionally, the debt ratio serves as another metric showing how much of a company’s total assets are funded by debt. Always ensure you check which ratio you are using and what it is telling you.

Conclusion: Should you depend on the Debt to Equity Ratio?

The debt to equity ratio is one of the commonly relied on ratios alongside the return of total assets ratio. Being a powerful and easy-to-use financial metric, it helps assess the level of risk exposure a company operates on. A noticeably low ratio indicates that a business uses capital efficiently while in contrast, a high ratio signifies the business tends to heavily rely on loans and credit.

Nonetheless, this ratio should not be considered in isolation. It is more useful with context and when mixed with other measures so that it paints a more complete picture. Always keep in mind to focus on comparing companies in the same industry. An abnormal ratio in one sector might be completely normal in another.

Whether you are a stock market investor, a business owner, or a finance student, make it a point to monitor the Debt to Equity Ratio. Always consider examining the ratio from reliable sources as part of your organisation's financial statements.

Most Popular Questions: Debt to Equity Ratio

What impact does having a high Debt to Equity Ratio have?

Using more debt than equity to finance their operations is what falls under this range. This can be quite dangerous especially if those loans need to be repaid on time.

Is it possible to consider a low debt to equity ratio as an advantage?

Yes and No, because the organisation might not be fully utilising its growth opportunities. Finding the right amount to draw from these pockets is the answer.

Where can someone go to check a firm's Debt to Equity Ratio?

These ratios can be accessed from the company's annual financial reports, informative platforms such as Screener.in, Moneycontrol, or data provided on stock exchange websites.