Hello friends. In this blog, we discuss various financial topics. That is why we have launched the ‘Stock Market Terms’ series. This is the eighth post of that series. The topic of our discussion in today’s post is the Debt to Equity Ratio. In the previous post, we discussed “Return on Capital Employed “.
What is Debt to Equity Ratio?
Debt to Equity Ratio is a solvency ratio. It is the comparison between the debt taken by the company and the total equity of the company. Basically, It measures the amount of long time & short term borrowings of a company in comparison to its total equity. The debt to equity ratio of a company can be found in the financial ratio section of the company.
Formula of Debt to Equity Ratio
The formula of the Debt to Equity Ratio is as below.
Debt to Equity Ratio = (Long Term Borrowings + Short Term Borrowings)/Shareholder’s Funds
Suppose, Company X has long term borrowings of Rs. 500 crore, short-term borrowings of Rs. 100 crore, and its total shareholder’s funds is 2000 crore. Hence, the Debt to Equity Ratio of Company X will be (500+100)/2000 = 0.33. This implies that for every Rs. 1 of Shareholder’s funds, Company X has taken the loan of Rs. 0.33.
A Real-Life Example of Debt to Equity Ratio
Now, let us understand this with a real-life example. At the end of March’21, the total long-term borrowings of Tata Motor was Rs. 16,326.77 crores while short-term borrowing was Rs. 2,542.50 crore and total shareholder’s funds were Rs. 19,055.97 crore. Hence, the debt to equity ratio will be = (16326.77+2,542.50)/ 19,055.97 = 0.99.
Usage & Interpretation of Debt to Equity Ratio
The ideal debt to equity ratio of a Company should be 0 (zero). However, almost all businesses take loans for their operation. Hence, debt-free companies are very rare. That is why an investor should look for companies whose debt to equity ratio is below 1. Why so? This is because, when the Debt to Equity ratio is more than 1, it means that the loan taken by the company is less than its equity. So, if in a year/years the company does not make a profit, it will survive. On the other hand, if a company’s debt to equity ratio is more than 1, it is very hard for the company to survive in the condition. How? Let’s understand this.
Suppose, Company Y has long-term borrowings of Rs. 800 crore, short-term borrowings of Rs. 100 crore and its total shareholder’s funds are 500 crores. Hence the Debt to Equity Ratio of Company X will be (800+100)/500 = 1.80. Now, let us assume that the company does not make a profit for a few years. Further company has to pay interest at the rate of 12% per annum. That means, every year it has to pay interest on its debt (900×12)/100 = 108 crores. Hence, if the company remains profitless for 5 years, it will be in a position to get bankrupt completely.
Further, while comparing Debt to Equity Ratio of two or more companies, investors should analyze companies of the same sector as Debt to Equity Ratio varies from sector to sector. For example, Debt to Equity Ratio of Financial Institutions, Power Sector are generally high whereas for Software, Retail companies, this ratio is very low.
Conclusion
The Debt to Equity Ratio is a very important solvency ratio. However, no investment should be done by considering this ratio only. An investor should check all the other financial ratios & parameters before investing in a company.
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PEG Ratio | Price to Earning Growth Ratio | Stock Market Terms 5