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.
Ankita is a graduate in English language and she has also done her MBA from the Calcutta University. She has a high knack in the stock markets. An experienced stock market content writer Ankita is also trading on her own account. Ankita is also preparing for the NISM Research Analyst Series XV examination seriously.
Categories: Stock Market Basics