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Introduction
The fundamental analysis becomes crucial before investing in a security. It typically includes analyzing the financial position of a company using various metrics. One metric that helps investors make an informed decision is a debt-to-equity ratio.
In this article, you will learn what is a debt-to-equity ratio in detail.
What is the Debt-to-Equity (D/E) Ratio?
The debt-to-equity ratio determines a company’s financial leverage. It is an essential metric for evaluating a company’s financial position and is calculated by dividing its total liabilities by its shareholder equity. According to the debt-to-equity ratio definition, it is a measure of the degree to which a company funds its operations with debt instead of its equity resources. Typically, the meaning of debt-to-equity is the amount of debt and equity a company uses.
For example, a debt-to-equity ratio of 2 indicates that for every Rs. 100 of equity, there is Rs. 200 in debt.
D/E Formula and Calculation
The debt-to-equity ratio formula is as follows-
Debt-to-Equity = Total Liabilities / Total Shareholder’s Equity
D/E is a financial metric that shows the company’s financial leverage in its business. Assets consist of total liabilities and additional equity. Calculating the D/E is straightforward as all the necessary parameters are readily available in the balance sheet. The ideal ratio varies by industry based on how much debt you have and how much cash you own. However, it generally determines a company's ability to repay its debts.
D/E provides an overview of leverage; however, understanding a company's proper leverage requires more attention to parameters such as retained earnings, adjustments, intangibles, and contingencies. As such, analysts may change ratios to facilitate comparisons with companies in the same industry.
How to calculate the D/E ratio in Excel
The debt-to-equity ratio interpretation is one of corporate finance's essential analysis metrics. Companies use various software to calculate such figures and metrics, but excel is the most commonly used software.
The first thing you need to do to calculate the debt-to-equity ratio in Excel is to find the company’s total debt and total shareholder’s equity on its balance sheet. You can input these two numbers in adjacent cells below the other, say B2 and B3, of a worksheet where you want to calculate the D/E ratio. Below the input cells, in cell B4, you can use the formula “= B2/ B3” to get your debt-to-equity value.
What does the D/E ratio tell you?
The D/E ratio means how much debt a company has against its shareholder’s equity. Shareholder equity refers to the company's net assets (Assets - Liabilities). Debt typically incurs interest expenses that cannot be deferred, and the whole debt amount must be repaid or refinanced. Debt can potentially impair or destroy the value of equity in the event of default. A high D/E ratio often means that the company relies primarily on debt financing, which increases the investment risk.
Debt-driven growth can help boost earnings, and shareholders should expect profits if the earnings increase outweighs the associated debt service costs. However, if the additional cost of debt financing outweighs the income it generates, the stock price may fall, and investors can lose their money. In addition, borrowing costs and a company's ability to repay them will vary depending on market conditions. Therefore, borrowing that may seem reasonable initially may be unprofitable, depending on the circumstances.
The D/E ratio tends to fluctuate more than current liabilities and current assets, so fluctuations in long-term liabilities and fixed assets tend to have the most impact. However, other metrics can be used when investors want to assess a company's short-term leverage and ability to meet its obligations due within a year.
Example of the D/E Ratio
Let’s say ABC company has a total liability of Rs. 75 crores and total shareholder’s equity of Rs. 52 crores, according to its Annual Report. Using the formula,
Debt-to-Equity Ratio = Total Liabilities / Shareholder’s Equity
= Rs. 75 crores / Rs. 52 crores = 1.44
This Debt-to-Equity interpretation can be that the ABC company has Rs. 1.44 of debt for every one rupee of equity. However, the D/E ratio alone cannot define anything to the investors. For a clearer picture of the company’s financial standing, it is essential to compare the ratio with other companies in the same industry.
Modifying the D/E Ratio
All liabilities are not equally risky. The long-term D/E ratio focuses on the riskier long-term debt by substituting that value for the total debt value in the numerator of the standard formula-
Long-term D/E ratio = Long-term debt / Shareholder’s equity
Short-term debt also increases a company's leverage, but these debts are less risky as they must repay them within a year. For example, imagine a company with Rs. 1 crore in current liabilities (wages, accounts payable, bills of exchange, etc.) and Rs. 50,00,000 in long-term debt, and a company with Rs. 50,00,000 in short-term payables and Rs. 1 crore in long-term debt. If both companies have Rs. 1.5 crore in equity, both companies have a D/E ratio of 1. It might seem the risks from leverage are the same, but in reality, the second firm is riskier.
Short-term debt is usually cheaper than long-term debt. It is less sensitive to changes in interest rates, which can result in higher interest expenses and cost of capital for the second company. Interest rates increase for long-term debts and higher interest expenses as long-term debt matures and needs refinancing.
Finally, assuming the company doesn't default next year, initial debt shouldn't be an issue. In contrast, a company's ability to service its long-term debt depends on its long-term business prospects, which is less certain.
The D/E Ratio for Personal Finances
The personal D/E ratio is often used by individuals and small businesses when applying for loans. Lenders use their D/E number to assess whether a loan applicant can continue to make loan payments in the event of a temporary loss of income.
The formula for the D/E ratio for personal finance remains almost the same-
Debt/Equity = Total personal liabilities / (Personal Assets - Liabilities)
For example, mortgage borrowers are more likely to be able to continue making payments during a prolonged unemployment period if they have more assets than debt. This also applies to individuals applying for small business loans or lines of credit. Suppose the business owner's debt-to-equity ratio is good. In that case, it is more likely that they will be able to continue making loan payments until her debt investment is recouped.
Limitations of the D/E ratio
As with any other financial metric, the debt-to-equity ratio has limitations. Some of these include the following:
● Considering the industry to make any sense of a company’s debt-to-equity ratio is essential.
● There lies an inconsistency in the definition of “liabilities” among analysts.
What is a good Debt-to-Equity (D/E) ratio?
The business model and the company's industry decide the goodness of any debt-to-equity ratio. For example, a debt-to-equity ratio good in the pharmaceutical industry might not be suitable for an FMCG industry. Typically, D/E ratios below one are considered relatively safe, while values above two are deemed risky. Companies in some sectors, such as utilities, consumer staples, and banks, typically have relatively high D/E ratios. Note that especially low D/E ratios can be a negative indicator as it shows that the company is not taking advantage of its leverage and tax benefits.
What does a Debt-to-Equity (D/E) ratio of 1.5 indicate?
The interpretation of a debt-to-equity ratio of 1.5 could be that the concerned company has Rs. 1.5 of debt for every one rupee of equity. For example, if a company holds assets worth Rs. 20 lakhs and liabilities worth Rs. 12 lakhs. Because equity equals assets minus liabilities, the company’s equity would be Rs. 8 lakhs. This brings us to the debt-to-equity ratio of 1.5.