Starting a small retail store can be an exciting journey! To kick things off, you’ll need some funds. You can tap into your personal savings or consider a loan from a bank or even a friend. The way you mix your own money with borrowed funds to run your shop is similar to what’s called the Debt-to-Equity Ratio, which is a term typically used by larger companies.

What is the Debt-to-Equity Ratio?

The Debt-to-Equity Ratio is like a report card that shows how a company pays for its business. Does it use more of its own money, or does it borrow a lot. This ratio helps you know if a company is strong or if it might have trouble paying back its loans.

• Debt is money a company borrows, such as a loan from a bank or money it owes to others.
• Equity is the money the company’s owners put in or the profits the company has saved up over time.

Example: Assume a company is a house. If you buy a house with mostly your own savings, you don’t owe much to anyone. But if you take a big loan to buy the house, you owe a lot. The Debt-to-Equity Ratio tells us how much of the “house” (the company) is paid for with loans versus your own money.

How Do We Calculate It?

The formula is very simple:

Debt to Equity Ratio = Total Debt ÷ Total Equity

Let’s say a company has:

• Debt (money it borrowed): ₹3,000 crore
• Equity (its own money): ₹15,000 crore

Now, divide the debt by the equity:

3,000 ÷ 15,000 = 0.2

This means for every ₹1 of the company’s own money, it has borrowed ₹0.20. That’s a low ratio, which is usually good because the company doesn’t owe too much.

Now, let’s try another example:

• A company has Debt: ₹500 crore
• Equity: ₹300 crore

500 ÷ 300 = 1.66

This means for every ₹1 of its own money, the company has borrowed ₹1.66. This is a higher ratio, so the company relies more on loans.

If this company borrows even more, say ₹200 crore, its total debt becomes ₹700 crore. Now:

700 ÷ 300 = 2.33

Now, for every ₹1 of its own money, it owes ₹2.33. This is a very high ratio, which can be risky.

Why Does This Ratio Matter?

The Debt-to-Equity Ratio is like checking if a company is carrying a heavy bag of loans or a light one. Here’s why it’s important:

Shows Financial Health: 

A low ratio (like 0.2 or 1) means the company doesn’t owe too much. It’s like a person who doesn’t have many loans and can easily pay their bills. A high ratio (like 2 or more) means the company has a lot of debt, which can be risky.

Helps Investors:

If you want to buy shares in a company (become a part-owner), this ratio tells you if it’s a safe choice. A company with too much debt might struggle to make profits or pay you dividends (a share of profits).

Helps Banks: 

When a company asks for a loan, banks check this ratio. If the ratio is too high, the bank might say, “You already owe too much, we can’t lend you more.”

Shows Risk of Bankruptcy: 

If a company has a very high ratio and its business slows down, it might not have enough money to pay back its loans. This could lead to big trouble, like closing the business.

Depends on the Industry: 

Some businesses, like factories, need a lot of money to buy machines, so they might have higher debt. Other businesses, like software companies, don’t need as much debt, so their ratio is lower. A good ratio is usually between 1 and 2, but it depends on the type of business.

What Happens if the Ratio is Negative?

Sometimes, a company’s Debt-to-Equity Ratio can be negative. This happens when the company owes more money than it has in assets (things it owns, like buildings or cash). For example:

• If a company has assets worth ₹100 crore but owes debt of ₹120 crore, its equity is negative (₹100 - ₹120 = -₹20 crore).
• A negative ratio is a big red flag. It means the company is in serious trouble and might go bankrupt.

How Does Debt-to-Equity Ratio Affect Profits?

There’s a connection between this ratio and something called Return on Equity (ROE), which measures how much profit a company makes for its owners.

Let’s imagine two companies:

• Company X has ₹80,000 in debt and makes a 20% profit for its owners.
• Company Y has ₹90,000 in debt (more than X) and makes a 24% profit for its owners.

Both companies have the same total assets (₹2,00,000) and earn the same profit from those assets (12%). But because Company Y borrowed more, it used that extra money wisely to make more profit for its owners. 

This shows that more debt can sometimes lead to higher profits, but only if the company uses the borrowed money well. However, too much debt is dangerous. If the company can’t make enough profit, it will struggle to pay back the loan, and its share price might fall.

What’s Bad About the Debt-to-Equity Ratio?

While this ratio is helpful, it has some problems:

High Debt Can Be Costly:

If a company borrows too much, it has to pay a lot of interest, like extra charges on a loan. This can eat up its profits and make it hard to survive.

It's Hard to Compare Companies:

Different companies calculate debt and equity in slightly different ways, making it tricky to compare them fairly.

Not Good for Unstable Companies:

If a company’s share price fluctuates frequently, the ratio might not tell the whole story.

Low Ratio Isn’t Always Good:

A very low ratio (like 0.2) might mean the company is strong and doesn’t owe much. But it could also mean the company isn’t growing because it’s not borrowing money to invest in new projects.

Things to Remember

• The Debt-to-Equity Ratio shows how much a company borrows compared to its own money.
• A low ratio (1 or less) usually means the company is safe and doesn’t owe too much.
• A high ratio (2 or more) means the company has a lot of debt, which can be risky.
• A negative ratio is a warning sign that the company might be in big trouble.
• The “right” ratio depends on the type of business. 
• Borrowing money can help a company grow and make more profits, but too much debt can cause problems.

Conclusion

Think of the Debt-to-Equity Ratio as a way to check if a company is carrying a heavy load of loans or travelling light. If you’re thinking of investing in a company or lending it money, this ratio is like a flashlight that shows you how risky it is. A ratio between 1 and 2 is usually a good sign, but always check what’s normal for the company’s industry. By understanding this simple number, you can make smarter decisions about where to put your money.