What is Debt to Equity Ratio?

Understanding this key term of debt to equity ratio is crucial for any finance student, investor, or business owner. This ratio assesses the company’s financial status and indicates the debt utilised in comparison to the equity owned by shareholders.

In this blog, we will cover the concept of debt to equity ratio in layman’s terms as well as describe its importance, advantages, risks, and significance along with how it is applied practically.

What is Debt to Equity Ratio?

The debt to equity ratio (also referred to as D/E ratio) is a financial term that benchmarks the total debt of a company to the shareholders' equity. This demonstrates whether funding for a company’s operations comes primarily from loans or their own cash reserves.

Formula:

Debt to Equity Ratio = Total Debt / Shareholders' Equity

A high ratio indicates excessive debt levels while a low level indicates reliance on internal funds.

The debt to equity ratio also carries a degree of importance for the following reasons:

Shows Potential Financial Issues

With a high debt ratio comes risk as the company may struggle to generate consistent revenue. The lower ratio, however, indicates that a company is relatively more financially secure.

Guides Investors To Make the Right Decisions

Investors also use this ratio while deciding whether to invest in a company or not. The company may be financially distressed if the ratio is too high.

Guides Financial Institutions When Granting Loans

This ratio also helps most bankers and lenders gauge the level of risk in funding a company. A balanced ratio helps to show that a business is capable of handling credit in a logical manner.

In Understanding Debt to Equity Ratio With A Simple Example:

Assume that a company holds ₹5 crores in shareholders' equity and ₹10 crores in debt.

D/E Ratio = ₹10 crores/₹5 crores = 2

This implies that for every ₹1 of equity, the company holds ₹2 in debt. This also shows that the company relies on loans more than its available funds which vary in nature depending on a country's industry.

In this scenario, if another company has ₹3 crore of debt and ₹6 crore of equity, then:

Debt to Equity Ratio = ₹3 crore / ₹6 crore = 0.5

This company is less leveraged, and therefore, safer in terms of risk.

What is Considered Good? Ideal Debt to Equity Ratio

Not all companies will have the same ideal ratio. What is considered a good debt to equity ratio varies with the industry and business model.

In capital-intensive industries such as airlines, infrastructure, and power companies, higher ratios (up to 2 or more) tend to be acceptable.

For service-based companies, especially IT firms, a lower ratio (less than 1) is preferred.

Generally, a debt to equity ratio of less than 1 is considered safe, while a ratio above 2 may suggest higher risk.

Advantages of Debt to Equity Ratio

Employing the debt to equity ratio has numerous benefits to investors, analysts, and business owners such as:

Straightforward, Yet Highly Impactful

Even though employing the ratio is straightforward, the results can reveal a lot about the company’s capital structure.

Aids in Company Evaluation

It provides the opportunity to analyse two or more competing companies in the same industry and evaluate their financial strategies.

Pertaining to Credit Policy

This ratio assists in determining whether a company qualifies for a loan or a credit facility.

Risk Assessment

This helps assess financial risk. An abrupt increase in the ratio can indicate some level of financial distress.

Risks associated with an increased debt to equity ratio

Debt can accelerate the growth of a firm. However, an excessive debt to equity ratio can be highly detrimental. This explains why:

Increased Cost of Interest

An increase in debt results in the firm having to make more interest payments. This diminishes their profits and cash flow.

Increased Risk of Default

The firm may default on the payment if they run at a loss. This may lead them towards bankruptcy.

Decreased Market Confidence

A firm having a very high debt is likely to be avoided by other firms, which indicates a lack of financial management.

Reduced Market Flexibility

Having a lot of debt makes the firm unable to take new initiatives or survive economic downturns.

When is the use of a high debt to equity ratio acceptable?

A high debt to equity ratio is not always a bad idea. There are certain situations where it is justifiable:

It enables radiating companies to scale up operations in a limited time.

It allows adding low-interest debts to equity in instances of low-interest rates.

Unlike utilities, high-volume cash flows are far easier to manage.

Even so, there is a threshold overload that must be kept in check.

Case Examples of Debt to Equity Ratio

As for the perspectives of various people, the debt equity ratio has different meanings:

As for Investors

Primary market investors look to gauge the capital structure of firms operating in the same area of activity while picking out the most beneficial investment.

For Company Managers

Entrepreneurs or owners of a company look to control this ratio in order to manage the level of debt so that they are always financially secure.

For Credit Rating Assigning Agencies

When rating a particular company’s creditworthiness, agencies tend to factor in the financial leverage ratio, such as CRISIL, ICRA, or CARE Ratings.

For Financial Analysts

Other analysts incorporated into the financial team use the ratio in their performance reports and during quarterly results analysis alongside other financial statements.

Debt to Equity Ratio and Competitors Ratio

And alongside other ratios, the debt to equity ratio is beneficial but must not be used in isolation; it has to be paired with other financial ratios like:

• Current Ratio – for liquidity measure
• Return on Equity (ROE) – to help measure profitability
• Interest Coverage Ratio – examine the rate of interest debt payments

The company's overall wellbeing benefits from this balance in regard to financial health.

Conclusion: Reasons for Monitoring Debt to Equity Ratio

In conclusion, out of all the financial ratios, the debt to equity ratio is one of the most effective in estimating a company’s risk level and examining its capital structure. It indicates whether the company is over-borrowing or managing its finances appropriately.

This ratio is important not only for an investor, business owner, or a finance student, but it is essential for anyone looking to make educated choices regarding finances. Always remember to evaluate this ratio alongside other benchmarks from the same industry and integrate it with other financial analyses for a more comprehensive understanding.