What is Debt to Equity Ratio?
Debt to equity ratio is a leverage ratio which identifies the sources of funds a company uses to run its operations. It is calculated by dividing a company’s total debt and liabilities by the shareholder’s equity. It measures the extent to which a company is using borrowed money to run its operations as opposed to its own funds. It ascertains the solvency or the scope of shareholder’s equity to settle the debts of the company.
Debt to equity = Total Debt / Total Shareholders’ equity
The data required in the formula can be found in the balance sheet of the company. Total debt includes all short term and long-term debts along with any fixed payment obligations that the company may have during its operations. Total shareholders’ equity represents the net assets owned by a company.
How can debt-to-equity ratio be interpreted?
A high debt-to-equity ratio suggests the company is depending more on borrowed funds than its equity to fund its operations. This is called debt financing. Debt financing can prove risky as it increases the fixed payment obligations and could even lead to insolvency in extreme cases. But debt financing ensures that the ownership rights remain with the company along with tax deductible payments.
A low debt-to-equity ratio, on the other hand, suggests the company has sufficient owned funds to run the operations and doesn’t need to tap into debts to provide funds. This is called equity financing. While equity financing ensures there is no additional financial burden, it comes with the disadvantage of giving ownership rights to the investors to the extent of their funds.
Limitations of Debt-to-equity ratio
While a high debt-to-equity ratio is dangerous for any company, the margin that defines if the debt-to-equity ratio is high or not should factor in the industry that the company is a part of. An ideal debt-to-equity ratio for a manufacturing or mining company will be higher than a company in the service industry because of their different capital requirements. Hence, a comparison of companies' debt-to-equity ratios across different industries should be made with caution.
So, what is the ideal debt-to-equity ratio?
As discussed earlier, debt-to-equity ratios for different industries vary and hence there can’t be an ideal ratio. But generally, a ratio below 1 is considered safe and a ratio exceeding 2 is considered risky. Industries like banking and manufacturing have debt-to-equity ratios exceeding 2 but for these industries this is common. A debt-to-equity ratio too low can mean that the companies are not availing the benefits of debt financing.
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