The Debt–Equity Ratio is a financial metric that measures the relationship between a company's total debt and shareholders' equity. It indicates the extent to which a business relies on borrowed funds compared to owners' funds for its operations. Debt refers to the money borrowed by the company that must be repaid with interest, while equity represents the funds contributed by shareholders and retained earnings. The Debt–Equity Ratio is one of the important solvency ratios used to assess a firm's ability to meet its long-term financial obligations. It helps evaluate the company's capital structure and financial stability by comparing the proportion of debt and equity financing. Generally, a lower Debt–Equity Ratio reflects a stronger financial position and lower financial risk, whereas a higher ratio indicates greater dependence on borrowed funds. Although a Debt–Equity Ratio of 2:1 is often considered ideal, the suitable ratio may vary depending on the nature of the business and industry. Therefore, companies should aim to maintain a balanced Debt–Equity Ratio to ensure long-term solvency and financial stability.
- Debt: Such obligations, which can be settled in subsequent operating cycles of the company, and not just in the one in which they were incurred, i.e., whose repayment period exceeds the period they were secured in are called debt. Examples include debentures, long-term loans from banks, capital leases, deferred income taxes, etc.
- Shareholders' Equity: These refer to the amount invested by the shareholders/owners in the business. It comprises two types of share capital: equity as well as preference share capital and is listed on the liabilities side of the Balance Sheet under the heading 'Equity'.
Formula:
where,
Long-term Debt = Redeemable Debentures + Interest on Debentures + Long- term loans from banks + Capital leases + Deferred income taxes
Shareholders' Equity = Equity Share Capital + Preference Share Capital + Reserves and Surplus (Excluding fictitious Assets) + Money received against share warrants
The following three situations can arise:
- If Debt-Equity Ratio = 1, it means the debt and equity are equal in amount, and hence, the firm is highly leveraged.
- If Debt-Equity Ratio > 1, it implies that the company has high debt obligations. This implies higher chances of bankruptcy and a lower rate of return on equity.
- If Debt-Equity Ratio <1, it implies that the firm has more investments by way of equity. This reduces the uncertainty that comes with interest obligations from outsiders' liabilities, thereby reducing the chances of bankruptcy.
Significance:
Debt-equity ratio depicts the financial leverage availed by the business and is an important measure of the solvency of the business. Creditors use the debt-equity ratio to decide whether further credit should be provided to the business or not since it helps them judge if the company is about to go bankrupt in the near future. Investors use the debt-equity ratio to determine the firm's capacity to generate a return on investment made by them. Management uses this ratio to study the capital structure of the firm.
Illustration 1:
Compute the debt ratio of ABC Ltd. from the following Balance Sheet:
Solution:
Total Debt = 20% Debentures + Long- Term Provisions + Bank Loan
= 1,50,000 + 1,00,000 + 3,00,000
= ₹ 5,50,000
Equity = Share Capital + Reserves and Surplus + Profit as per Income Statement
= 8,00,000 + 4,00,000 + 45,000
= 12,45,000
= 0.44:1
Illustration 2:
Compute the debt ratio of P Ltd. from the following information:
Total Debt 20,00,000; Capital Employed 25,00,000; Current Liabilities 4,00,000.
Solution:
Long-term Debt = Total Debt - Current Liabilities
= 20,00,000 - 4,00,000
= 16,00,000
Capital Employed = Shareholders' Funds + Long-term Liabilities
25,00,000 = Shareholders' Funds + 16,00,000
Shareholders' Funds = 9,00,000
= 1.77:1
