The Debt-Equity Ratio is a measure used to analyse the financial leverage of a company. The ratio is an outcome of the division of the company’s total liabilities by the shareholder’s equity. It shows the level of debt used to finance its assets compared to the amount of shareholder’s equity.
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The formulae to find the Debt Equity Ratio is represented as:
Debt to Equity Ratio = Total Liabilities / Shareholders’ equity
This ratio is often represented in a percentage form. It is also known as risk or gearing.
This ratio is used in all the financial statements of the corporate. Here, the equity is not considered as the value of shares of shareholders but is derived from the difference between personal assets and personal liabilities. The ratio thus can also be represented as
Debt Equity Ratio = Total Liabilities / Total Assets – Total Liabilities
Breakdown of Debt Equity Ratio
As the ratio is a measure of the debt of a company relative to the total asset value it is a means to evaluate the leverage of the firm. A high Debt Equity Ratio will mean the business has attained growth with more debt which implies a high level of risk. Further, this results in increased interest expenses.
If using debt can increase the earnings of the firm compared to what it would have made without debt, and further if it is able to cover its interest costs, then shareholders can expect better returns on their investments. But if the company’s debt outweighs the gains from operations, the share values shall decline, and increased debt would lead to bankruptcy.
The debt-equity ratio is often used in financing when an individual or a firm applies for a loan. They check the ratio to ensure financial sustainability of the same. The financial institution will not have much confidence in the person possessing a high debt-equity ratio as they will not be sure about repayments of the loan and interest.
On the other hand, the candidate with a lower percentage will be given preference as they give better assurance of repayment of the loan in future.
Limitations of the Debt Equity Ratio
Though Debt Equity Ratio is imperative like the other ratios for a firm, it can be compared with a business of one industry to the other. One industry may have a different way of operation, and a higher debt might be common, but for the other, it would not mean the same. For example, if we consider the firms manufacturing personal computers, their average debt-equity ratio is 0.5.
On the other hand, the auto manufacturing company might have a ratio of 2 and is considered standard because it is a capital-intensive industry. Thus, these ratios are valid only in comparing firms within an industry.
Total liabilities may be determined in different ways for different companies. Thus, the liabilities aren’t the same for all the companies. Some will only consider loans and debt securities as liabilities in the formulae, and some would also consider short term obligations. The equations fail to state the actual meaning of liabilities in this case.
A company might have long-term debts that are near maturity and are further shown as short terms debts. Thus, these differences require particular attention to come to a conclusion regarding the calculation of ratios and analysis of the same.