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What is the debt to equity ratio?
Cut your coat according to your cloth! This self-explanatory proverb is one of the most important life lessons. In the finance world, it directly translates to spend in accordance with how much you have and lend in accordance with how much you can payback. We have financial ratios to represent many aspects of numerically. This is the debt to equity ratio interpretation in simple terms. Now that we have our basic structure ready, let’s get into the technical aspects of this ratio.
What does the ratio mean?
Debt to equity ratio formula is calculated by dividing a company’s total liabilities by shareholders’ equity.
DE Ratio= Total Liabilities / Shareholder’s Equity
Liabilities: Here all the liabilities that a company owes are taken into consideration.
What is shareholder’s equity: Shareholder’s equity represents the net assets that a company owns.
Net Assets= Assets -Liabilities
SE stands for the company’s owners’ claim over the company’s value after the debts and liabilities have been paid for.
Fact: Every shareholder in a company becomes a part-owner of the company. Your ownership depends on the percentage of shares you own in proportion to the total number of shares that a company has issued.
A company’s creditors (lenders and debenture holders) are always given more priority than equity shareholders.
Hence they are paid off before the owners (shareholders) are paid back their claim on the company’s assets.
SE represents the ability of shareholder’s equity to cover for a company’s liabilities. SE can be negative or positive depending on the company’s business. It is an important metric for a company’s financial health and in turn, makes the DE ratio an important REPRESENTATION of a company’s financial health.
Where can you find the information: All the information on a company’s assets and liabilities can be found in a company’s balance sheet.
Debt to equity ratio interpretation
Debt to equity ratio helps us in analysing the financing strategy of a company. The ratio helps us to know if the company is using equity financing or debt financing to run its operations.
High DE ratio: A high DE ratio is a sign of high risk. It means that the company is using more borrowing to finance its operations because the company lacks in finances. In other words, it means that it is engaging in debt financing as its own finances run under deficit.
Low DE ratio: This means that the company’s shareholder’s equity is in excess and it does not need to tap its debts to finance its operations and business. The company has more of owned capital than borrowed capital and this speaks highly of the company.
A high debt to equity ratio, as we have rightly established tells us that the company is borrowing more than using its own money which is in deficit and a low debt to equity ratio tells us that the company is using more of its own assets and lesser borrowings.
Now by definition, we can come to the conclusion that high debt to equity ratio is bad for a company and is viewed negatively by analysts.
Misnomers in the interpretation:
If we look at the debt to equity ratio formula again, DE ratio is calculated by dividing total liabilities by shareholders’ equity. Depending on the nature of industries, a high DE ratio may be common in some and a low DE ratio may be common in others
Capital intensive industries like manufacturing may have a higher DE ratio whereas industries centered around services and technology may have lower capital and growth needs on a comparative basis and therefore may have a lower DE.
Therefore, what we learn from this is that DE ratios of companies, when compared across industries, should be dealt with caution.
How to calculate debt to equity ratio?
There are two main components in the ratio: total debt and shareholders equity. Shareholder’s equity is already mentioned in the balance sheet as a separate sub-head so that does not need to be calculated per say. What needs to be calculated is ‘total debt’.
As the term itself suggests, total debt is a summation of short term debt and long term debt.
Let’s look at a sample balance sheet of a company.
We have taken the balance sheet of Reliance Industries Ltd. as of March 2020 as a sample for this example.
|Standalone Balance Sheet||——————- in Rs. Cr. ——————-|
|Mar 20||Mar 19||Mar 18||Mar 17||Mar 16|
|12 mths||12 mths||12 mths||12 mths||12 mths|
|EQUITIES AND LIABILITIES|
|Equity Share Capital||6,339.00||6,339.00||6,335.00||3,251.00||3,240.00|
|Total Share Capital||6,339.00||6,339.00||6,335.00||3,251.00||3,240.00|
|Reserves and Surplus||418,245.00||398,983.00||308,297.00||285,058.00||236,936.00|
|Total Reserves and Surplus||418,245.00||398,983.00||308,297.00||285,058.00||236,936.00|
|Total Shareholders Funds||424,584.00||405,322.00||314,632.00||288,309.00||240,176.00|
|Equity Share Application Money||0.00||0.00||15.00||4.00||8.00|
|Long Term Borrowings||178,751.00||118,098.00||81,596.00||78,723.00||77,866.00|
|Deferred Tax Liabilities [Net]||50,556.00||47,317.00||27,926.00||24,766.00||13,159.00|
|Other Long Term Liabilities||3,428.00||504.00||504.00||0.00||0.00|
|Long Term Provisions||1,410.00||2,483.00||2,205.00||2,118.00||1,489.00|
|Total Non-Current Liabilities||234,145.00||168,402.00||112,231.00||105,607.00||92,514.00|
|Short Term Borrowings||51,276.00||39,097.00||15,239.00||22,580.00||14,490.00|
|Other Current Liabilities||186,787.00||73,900.00||85,815.00||60,817.00||54,841.00|
|Short Term Provisions||1,072.00||783.00||918.00||1,268.00||1,170.00|
|Total Current Liabilities||310,183.00||202,021.00||190,647.00||152,826.00||125,022.00|
|Total Capital And Liabilities||968,912.00||775,745.00||617,525.00||546,746.00||457,720.00|
|Intangible Assets Under Development||0.00||6,402.00||6,902.00||4,458.00||9,583.00|
|Long Term Loans And Advances||44,348.00||31,806.00||17,699.00||10,418.00||16,237.00|
|Other Non-Current Assets||4,458.00||4,287.00||3,522.00||2,184.00||0.00|
|Total Non-Current Assets||802,315.00||622,818.00||493,613.00||440,465.00||367,156.00|
|Cash And Cash Equivalents||8,443.00||3,768.00||2,731.00||1,754.00||6,892.00|
|Short Term Loans And Advances||15,028.00||4,876.00||3,533.00||4,900.00||11,938.00|
|Total Current Assets||166,597.00||152,927.00||123,912.00||106,281.00||90,564.00|
Shareholders equity = Rs 4,05,322 crore
Total debt= short term borrowings + long term borrowings
Rs (1,18, 098 + 39, 097) crore
Rs 1,57,195 crore
Lets put these two figures in the debt to equity formula:
DE ratio= Total debt/Shareholder’s equity
Rs (1,57,195/4,05,322) crore
0.39 (rounded off from 0.387)
The debt to equity concept is an essential one. It uses aspects of owned capital and borrowed capital to indicate a company’s financial health. By using values of shareholders equity for borrowed capital and total debt (including short and long term debt) for borrowed capital, DE ratio checks if the company’s reliance is more on borrowed capital(debt) or owned capital.
If the company has borrowed more and it exceeds the capital it owns in a given moment, it is not considered as a good metric for the company in question. Then what analysts check is if the company will be able to meet those obligations.
Is there an ideal DE ratio?
The short answer to this is that the DE ratio ideally should not go above 2. A DE ratio of 2 would mean that for every two units of debt, a company has one unit of its own capital. This is extremely high and indicates a high level of risk.
The long answer to this is that there is no ideal ratio as such. Yes, a ratio above two is very high but for some industries like manufacturing and mining, their normal DE ratio maybe two or above. Whereas for other industries a DE ratio of two might not be normal. What we need to look at is the industry average.
Hence, we can derive from this that caution needs to be exercised when comparing DE, and the same should be done against companies of the same industry and industry benchmark.