What is debt equity ratio?
Debt equity ratio means how much capital, equity or money a company has to repay its borrowed money. The debt-to-equity (Debt/Equity) ratio is calculated by dividing a company’s total liabilities by its shareholder equity. These numbers are available on the balance sheet of a company’s financial statements.
The ratio is used to evaluate a company’s financial leverage. The Debt/Equity ratio is an important metric used in corporate finance. It is a measure of the degree to which a company is financing its operations through debt versus wholly owned funds. More specifically, it reflects the ability of shareholder equity to cover all outstanding debts in the event of a business downturn. Therefore, it is very important for any business to know that what is good debt to equity ratio.
The debt-to-equity ratio is a particular type of gearing ratio.
Debt Equity Ratio Formula
If we divide total liabilities of a company by its total shareholders equity, resultantly we will get the debt to equity ratio.
What is good debt to equity ratio
Normally, debt to equity ratio of 1:1 is known to be a good debt equity ratio. It means the company have a balanced debt to equity ratio and ensure profitability. Debt equity ratio of 1:1.5 is know to be the best debt equity ratio, which means the company have enough resources available to pay off all of its debt without any problem. but the ratio is really industry specific because it includes the proportion of current and non-current assets.
How to Calculate the Debt Equity Ratio
The information needed for the Debt/Equity ratio is on a company’s balance sheet. The balance sheet requires total shareholder equity to equal assets minus liabilities, which is a rearranged version of the balance sheet equation (assets = liabilities + shareholder equity).
These categories from balance sheet may include individual accounts that would not generally be considered as “debt” or “equity” in the traditional sense of a loan or the book value of an asset. Because the ratio can be distorted by retained earnings/losses, intangible assets, and pension plan adjustments, further research is usually needed to understand a company’s true leverage.
Because of the ambiguity of some of the accounts in the primary balance sheet categories, analysts and investors will often modify the Debt/Equity ratio to be more useful and easier to compare between different stocks. Analysis of the Debt/Equity ratio can also be improved by including short-term leverage ratios, profit performance, and growth expectations.
Importance of Debt Equity Ratio
Debt to equity ratio – which is a measure of company’s financial leverage – is an important ratio to known the stability and profitability of a company. It shows how much a company rely on borrowed finance and its ability to pay off that borrowed money. For investors, the debt equity ratio shows how risky the business is as an investment. Healthy ratios vary by industry, but the general rule of thumb for investors is: A higher ratio means a higher risk of bankruptcy in the event of a recession. This is the reason, investors usually like companies with debt equity ratio at or below the average for that particular industry. This is why management of a company always keep an eye on it and try to improve this ratio.
Let’s have a look on a real life example of debt to equity ratio of ABIL Group. The company had Debt/Equity Ratio of -49.10 as provided in the financial indicators for financial year ending on 31 March, 2016. Managing director of ABIL Group one of the top builders in Pune India, Amit Bhosale reveals that a key policy of the company is to keep its debt to equity ratio at 1:1 to ensure profitability.
Each business industry has a different debt equity ratio standards because some industries need more financing than others. In a situation when you need financing, you need to put up some of your own cash to make deal work. When this option is not available, you may need to look for equity options, where you will give up ownership in lieu of cash.
Investors normally consider debt as a burden, whether it is on themselves or on a company they plan to invest in. While analyzing a company for investment in, investors should check how much debt the company has. Because high debt levels discourage investors from investing in such companies as most of the company’s profits might get crumbled by interest payments leaving very small amount for the equity holders. Investors can gauge the company’s ability to service its debt by checking out the interest coverage ratio
Negative debt equity ratio
Negative debt equity ratio shows that the value of a company is negative. Let’s take it in simple words, equity is the difference between assets and liabilities as explained in the accounting equation. The difference generally denotes the amount of equity available to a company. When it shows a negative result, then there is said to be no value left in the company.
Negative debt equity ratio has following implications:
Dissolution of a company
Theoretically a company is left with no value when it has a negative debt to equity ratio. It means that company is going to disappear soon or later or its owner have to get additional investment or be taken over by other business entities in the industry.
Unattractive to investors
Nobody will want to invest in a company with negative equity. Investors will look into such company as a disaster and they will never invest in such a company and will never advise anybody to invest in. Hence, the company becomes literally unattractive.