Debt to Equity ratio formula, interpretation with Examples.

 

Debt to Equity ratio formula, interpretation with Examples.

                   Credit: Image by Photo by Mohamed Hassan from PxHere

Looking ahead at the great future prospectus of the business, promoters require a lot of capital but from where does this capital comes from? 

There are two types to raise the capital. Either by raising the Equity or Debt from banks, financial Institutes, Private lenders, or any other resources.

But each type i.e. equity or the debt has its own impact on the business. Equity is the ownership in the business or company and does not require to be paid regularly but debt is a liability that has to be paid on regular basis like interest.

Equity can be raised in three ways

Equity Share Capital: Initial Investment by promoters.

Reserves & Surplus: Cash + Profit ( This maybe after a few years as the company grow their business they will earn some profit and all profit will not be used or distributed to shareholders but they keep theses money as a reserve.)

Preferred Shares or Equity. This can be raised from friends and families or strategic partners by creating confidence and promise that they will get some percentage of money on their investment than the other common equity shareholders

Equity Capital, Reserve & Surplus are considered as Common Equity.

Total equity includes common + preferred equity

Liabilities are also two types of liabilities

Current Liabilities: Its payment condition is within 1 year. It includes short term dues, Trade Payables, Advances & Overdue, and other short term dues.

Noncurrent Liabilities: Its payment condition is after 1 year. It includes long term debt (loan), Differed tax liabilities and other long term liabilities.

The all the above statements are applicable for the promoters but as an investor who has to invest in this company’s stock what he is looking is the stock may increase or decrease but at least his money should be protected. It should not become zero (this will happen in case of bankrupt of the company).

So in order to know the solvency of the company debt to equity ratio is important to understand.

How Debt to Equity Ratio calculated? How to interpret the Debt to equity ratio? Let us understand.

For any business Liquidity tells us the short term position of the company and Solvency tell us the overall condition of the company like the short term and long term position of the company.

Total Debt =Long term debt + Short Term debt.

Long term debt come to know from noncurrent liabilities which are mentioned in company’s balance sheet.

Short term debt come to know from current liabilities which are mentioned in company’s balance sheet.

For Example Company A has

Long term Debt = 100Crore

Short Term debt = 50 Cr.

Equity capital      = 100 Cr

Then D/E = 150/100

                   = 1.5.

Interpretation of the D/E ratio.

Important points

·         Ideally D/E < 1.: If D/E is less than 1 means the company is in the conformable zone. Because if the debt is lower than the equity then the company has money to refund the debt i

·         Tougher Times –Low D/E companies will survive better. In the case of bad economic conditions or low business, the lower D/E companies will survive. Because debt is a mandatory payment in spite of business conditions.

·         High debt may lead to the situation of a bankrupt company.

·         For comparing the D/E of the companies you should compare with the companies from the same sector.

·         High capital intensive companies like the power plant, petrochemical plant, Banks Construction, etc., always have high D/E.

·         Low capital intensive companies like software, retail have low D/E.

Let us understand by the live example of the two companies from the same sector.

1.       Asian Paints &

2.      Berger Paints

BALANCE SHEET OF ASIAN PAINTS (in Rs. Cr.)	Mar-20		BALANCE SHEET OF BERGER PAINTS INDIA (in Rs. Cr.)	Mar-20
	12 months			12 months
EQUITIES AND LIABILITIES			EQUITIES AND LIABILITIES
SHAREHOLDER'S FUNDS			SHAREHOLDER'S FUNDS
Equity Share Capital	95.92		Equity Share Capital	97.12
TOTAL SHARE CAPITAL	95.92		TOTAL SHARE CAPITAL	97.12
Reserves and Surplus	9,357.37		Reserves and Surplus	2,527.92
TOTAL RESERVES AND SURPLUS	9,357.37		TOTAL RESERVES AND SURPLUS	2,527.92
TOTAL SHAREHOLDERS FUNDS	9,453.29		TOTAL SHAREHOLDERS FUNDS	2,625.04
NON-CURRENT LIABILITIES			NON-CURRENT LIABILITIES
Long Term Borrowings	18.5		Long Term Borrowings	0
Deferred Tax Liabilities [Net]	282.68		Deferred Tax Liabilities [Net]	29.14
Other Long Term Liabilities	501.32		Other Long Term Liabilities	206.79
Long Term Provisions	136.78		Long Term Provisions	3.41
TOTAL NON-CURRENT LIABILITIES	939.28		TOTAL NON-CURRENT LIABILITIES	239.34
CURRENT LIABILITIES			CURRENT LIABILITIES
Short Term Borrowings	0		Short Term Borrowings	222.46
Trade Payables	1,760.08		Trade Payables	1,012.92
Other Current Liabilities	1,390.83		Other Current Liabilities	212.95
Short Term Provisions	44.14		Short Term Provisions	29.99
TOTAL CURRENT LIABILITIES	3,195.05		TOTAL CURRENT LIABILITIES	1,478.32

 

 

Asian Paints:      

Total Shareholders fund = 9,453.29

Long term Borrowings =   18.5

Short term Borrowings = 0.0

D/E                                      = 18.5/9453.29

                                              = 0.0019

Berger Paints:

Total Shareholders fund = 2625.04

Long term Borrowings =   0

Short term Borrowings = 222.46

D/E ratio                         = 222.46/2625.04

                                          = 0.08.

From the above calculation both the companies are having the D/E ratio below 1 but the Asian Paint (0.0019) is in a better position than Berger Paints (0.08)

But for choosing the stock for investment one should not rely only on one financial ratio but all other financial ratios are to be compared.

Debt to equity ratio in personal finance

This ratio can also be used in personal finance also. Particularly in case of loan. While lending a loan the bank or financial institutes look after borrower’s capacity to repay the loan that is why while sanctioning the loan Bank generally ask the borrower about the source of income, any other loan if he has, the property he has.

In this case, the term equity refers to the difference between total assets value and total liabilities.

It can be represented as:

Personal debt/equity ratio = total personal liabilities / (total personal assets – total liabilities)

 

What does D/E ratio tells us

·         D/E ratio gives the comparison of total liability to equity. (As mentioned above in the example)

·         The Debt/Equity ratio is used by lenders to gauge the financial situation of a borrower and make a judgment regarding their repayment ability.

·         In general higher the D/E ratio higher is the risk to invest in the stock for the investor.

·         It helps Investor to decide for investment in the stock by comparing the D/E ratio of the same type of the company.