Debt-to-equity ratio is the key financial ratio and is used as a standard for judging a company’s financial position. This ratio is an important metric used in corporate finance & serves as a measure of a company’s ability to repay its obligations.
In simple words, the ratio of the total long term debt and equity capital in the business is called the debt-equity ratio.
FORMULA OF DEBT – EQUITY RATIO
The debt to equity ratio is calculated by dividing the total long-term debt of the business by the book value of the shareholder’s equity of the business.
Debt to Equity =
Total Long-Term Debt/Shareholder’s Equity
Long term Debt = All the obligations which have a maturity of more than a year. Example, mortgages.
Shareholder’s equity = The net assets that a company owns.
i.e Net Assets = Assets – Liabilities
INTERPRETATION OF THE RATIO :-
The Debt – Equity ratio is used to determine whether a company is using equity financing or debt financing to run its operations.
HIGH DEBT- EQUITY RATIO – A high ratio indicates that a company is more dependent on debt to finance its operations as compared to equity which means that it is lacking finances. A high ratio is not favourable for a concern.
LOW DEBT – EQUITY RATIO – A low ratio indicates that a company has enough shareholder’s equity and it does not need to borrow funds from outside sources . Hence, a low ratio is favourable for a concern.
Thus, a company should try to keep its debt – equity ratio as low as possible as it helps in attracting additional capital for further investment and expansion of the business & indicates the financial stability of the company.
A ratio of less than 1 is generally considered ideal for the companies & a ratio of greater than 1 is considered risky for the companies.
Normally, this Debt – equity ratio depends upon the nature or type of the industry. Say, for example , Companies that are heavily capital intensive may have higher debt to equity ratios while service firms will have lower ratios.
Thus, understanding the debt to equity ratio in this way is important to allow the management of a company to understand how to finance the operations of the business firm.