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, and analyst observe how efficiently and smartly a company use debt to raise its asset. Debt to equity ratio measures the liability 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 liability a company has. D/E Ratio Formula is quite simple to calculate.
Debt to Equity Ratio Formula:
It is a ratio between total liability 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 from a company’s balance sheet.
How to Analyze the Debt to Equity Ratio?:
A D/E ratio of less than 1 indicates a financially stable business and more than 1 implies an unstable business which is more risky to creditors and investors. By using the ratio one can analyze company performance.
For example, if a company’s total liability is 600,000 and shareholders’ equity is 1,200,000, then the D/E ratio is near 0.5 which is lower than 1 that shows stable and efficient business growth.
Limitations of the D/E ratio:
Each industry has a different D/E ratio because some industries like motors, infrastructure, power sector, etc tend to use more financing debt than other industries. Hence, a company with a high debt-to-equity ratio is not always bad. You need to check out other data along with the D/E ratio for analysis.
From the above statement, we can observe the difference between the 2 different sectors’ D/E variation. General Motors, Ford Motors’ D/E ratio is much higher than the other sector. The reason behind the high D/E ratio is not an unstable business but the debt requirements for buying heavy equipment.
Generally speaking, a healthy D/E ratio should range from 0.5 to 1. It indicates the amount of leverage that a company is taking on and it’s capacity to pay back creditors.
Yes, it is considered as an optimum level for most companies since lower ratios indicate efficient usage of equity while higher numbers may signify too much reliance on borrowed funds or a shaky financial health picture of the company.
If your chosen stock’s D/E Ratio has crossed 1 (ie., it’s greater than one), then consider this as an extreme caution sign unless there are very strong reasons such as heavy investing in businesses with high return expectations justifying those expenses taken up by external borrowing sources over debts raised through internal means like Equity capital issue, etc.
The D/E Ratio of 1.5 implies that the company has $150 worth of total liabilities for every $100 worth of funding which comes from common stockholders’ capital & retained earnings. This implies a balancing act in establishing adequate liquidity while limiting overall financial risk exposure.
So, investors or traders must remember the twist discussed here while analyzing the D/E ratio. It is one of the important indicators of fundamental analysis. Debt to Equity ratio can give an instant idea of a company’s cash flow. However, while analyzing consult other indicators too side-by-side for a better understanding of any company.