Debt to Equity Ratio

Posted in Finance, Accounting and Economics Terms, Total Reads: 1408
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Definition: Debt to Equity Ratio

Debt to Equity Ratio is a ratio which is mainly the company's liabilities divided by total shareholder's equity. Debt to Equity ratio shows how much leverage does a company have or simply said how much debt a company has as when compared to its equity.

Debt is a cheaper source of finance than the equity shares. So an organization tries to use as much debt as possible to increase the ROE (Return on Equity). But there’s an extent to which an organization can optimally employ debt in its capital structure.

Debt to equity ratio measures the long term solvency of the firm. It helps the investors to analyse the capital structure of the firm. The potential of further employment of debt in the company can be found out.

Formula

Debt to Equity Ratio : Total Liabilities/Total Shareholder's Equity

(Total Shareholder's Equity=Equity+Reserves)

There are basically 2 formulae:

  1. Long term Debt/Total Shareholder's Equity
  2. Total outside liabilities/Total Shareholder's Equity

Example

if the Total assets of the company are Rs. 1,00,000. Consisting of Rs. 25,000 equity; Rs. 50,000 long term debt; and Rs. 25,000 other outside liabilities

Therefore the debt to equity ratio is either:

  1. 50000/25000 – i.e. 2:1 (or)
  2. 75000/25000 – i.e. 3:1

If the debt equity ratio is too high, then the firm has less potential to employ further debt in the company. The present creditors of the firm will then restrict the company’s cash usage if the debt equity ratio is too high.

Debt to Equity Ratio may vary as per industry also. We should not compare D/E ratio of a company in a particular industry to a ratio in other industry. Some industries may require more debt as compared to other industry so Debt to equity ratio may vary accordingly. Somewhere a 0.5 ratio may be good but in some other industry even 3 might be good from operational point of view.


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