A company’s debt consists of its long-term debts such as loans with a maturity of more than one year. On the other hand, equity refers to the shareholder’s equity or what the investors in our business owners. Together, debt and equity both compose a company’s capital structure or how it finances its operations. The debt to equity ratio comprises both.
The Debt to Equity ratio indicates how much debt and how much equity a company or business uses to runs its financial operations. It measures solvency and researches the capital structure of a company. It is used to assess a company’s financial position. In simple words, it is the measure of the relative contribution of shareholders/investors and creditors in the capital employed in the company.
The debt to equity ratios highlights if the capital structure of the company is titled towards debt or equity financing. It estimates the weight of total debt against total shareholder’s equity. The proportion also reflects the ability of shareholder’s equity to cover all the debts in event of any business downturn.
CALCULATION OF DEBT TO EQUITY (D/E) RATIO:
There are two components taken into consideration while evaluation of D/E ratios: Shareholders’ equity and total debt (liabilities). Both of these can be taken from the balance sheet of a company directly. The debt to equity proportion is calculated by dividing total long-term debt by shareholder’s equity.
Debt to Equity Ratio = Total Debt / Shareholder’s Equity
Let’s consider a small company that has ₹1,00,000 in shareholder’s equity and owes ₹1,10,000 to debtors, then the debt to equity is
Debt to Equity Ratio= Total Debt / Shareholder’s Equity
= 110000 / 100000
INTERPRETATION OF DEBT TO EQUITY RATIO:
The debt to equity helps to analyze a company’s financial strategy. The ratio shows the debt of a company as a percentage of its shareholder’s equity. A high ratio is a sign of risk and it indicates that the company is using more borrowing to finance its operations. On the other hand, a low ratio means that the company’s shareholder equity is in excess. It states that the company has more owned capital than borrowed capital.
Generally, a good debt to equity proportion is anything lower than 1.0. A proportion more than 2.0 is usually considered higher and riskier. If a debt to equity ratio is negative, it indicates that the company has more liabilities than assets. A negative ratio is an indicator of bankruptcy.
SIGNIFICANCE OF DEBT TO EQUITY RATIO:
The debt to equity ratio is significant for the analysis of a company. Let’s see some reason why it is necessary to consider it.
The debt to equity ratio is a crucial assessment ratio that potential investors use to study the financial health of a company.
A high debt to equity ratio states low liquidity. It also states that the business is unable to finance its obligations and is dependent on the creditors.
The D/E proportion helps in understanding the earnings of a shareholder.
The creditors also use the proportion to understand the creditworthiness of a company.
A high debt to equity proportion indicates that the company is paying high interest which is significantly cutting down the profits.
A cut down in profit means a decrease in the dividends paid to the ordinary shareholders.
The debt to equity ratio is one of the most reliable ratios in estimating the long-term financial stability of a company. It shows the total of debt and equity used to finance a company’s assets. Investors judge a company based on this proportion. Their decision regarding whether to invest in a company or not is dependent on the debt to equity ratio. Also, the creditors view this ratio before reaching any conclusion. Hence, the debt to equity ratio is a vital instrument to judge the financial health of a company.
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