Usually, the term ‘debt’ refers to liability. Generally, people like to live a debt-free life but when someone is running a business, debt is one of the requirements. In fact investors, financial institution, analyst observe how efficiently and smartly a company use the debt to raise its asset. Debt to equity ratio measures the debt of a company, use to finance its asset relative to the value of shareholders’ equity. The ratio explains for every rupee of equity how much debt a company has. Debt to Equity Ratio Formula is quite simple to calculate.
Debt to Equity Ratio Formula:
It is a ratio between total debt and shareholders’ equity. The ratio is calculated by dividing total liabilities by stockholders’ equity. The formula is stated below:
Debt to Equity Ratio=Total Debt / Shareholders Equity
The numerator consists of short-term debt, long-term debt, and other fixed payments. The denominator consists of the total equity of shareholders including preferred stocks.
One can assemble the data by a company’s balance sheet.
D/E ratio less than 1 indicates a financially stable business, and more than 1 implies unstable business which is more risky to creditors and investors. By using the ratio one can analyze a company performance.
As for example, if a company’s total debt is 600,000 and shareholders’ equity is 1,200,000, then D/E ratio is near 0.5 which is lower than 1 that shows a stable and efficient business growth.
Limitations of D/E ratio:
Each industry has different D/E ratio because of some industries like motors, infrastructure, power sector etc tend to use more financing debt than other industries. Hence, a company with high debt to equity ratio is not always bad. You need to check out other data along with D/E ratio for analysis.
From the above statement, we can observe the difference between 2 different sectors’ D/E variation. General Motors, Ford Motors’ D/E ratio are much higher than the other sector. The reason behind high D/E ratio is not the unstable business but the debt requirements for buying heavy-equipments.
So, investors or traders must remember the twist while analyzing D/E ratio. However, it is one of the important indicators of fundamental analysis.
Categories: Stock Market Basics