Debt to Equity (D/E) Ratio

The debt-to-equity (D/E) ratio is a financial metric that compares a company's total debt to its shareholder equity to show how much it relies on borrowing versus owner capital. In this article, let's explore the D/E ratio, formulae and many more.

Key Highlights:

• The debt-to-equity ratio indicates the overall debt of the company.
• The D/E ratio influences a company's weighted average cost of capital (WACC) and return on equity (ROE).
• The low D/E ratio is considered a sign that the company is safe to invest in.

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 determine if a company is financially strong or if it might struggle to repay its loans.

• Debt refers to the 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 home with mostly your own savings, you don’t owe much to anyone. But if you take out a large loan to buy the home, you'll end up owing 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 to Calculate Debt to Equity Ratio?

The formula is straightforward:

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 two 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 significant trouble, such as closing the business.

Depends on the Industry: 

Some businesses, such as factories, require significant investments in machinery, which can lead to higher debt levels. Other firms, such as software companies, require less debt, resulting in a lower ratio. 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%). However, because Company Y borrowed more, it utilised the additional funds wisely to increase profits for its owners. 

This indicates that increased debt can sometimes result in higher profits, provided the company utilises the borrowed funds effectively. However, too much debt is dangerous. If the company can’t generate sufficient profit, it will struggle to repay 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) typically indicates that the company is financially stable and doesn’t owe too much.
• A high ratio (2 or more) means the company has substantial 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 increase profits, but excessive debt can lead to problems.

Conclusion

A high debt-to-equity (D/E) ratio indicates that a company relies heavily on debt, which increases financial risk but may also fuel growth. A low ratio suggests financial stability and less risk, but may also signal missed growth opportunities. The ideal D/E ratio varies by industry, so it's essential to compare and invest wisely.