What is Debt Equity Ratio & its Significance?

by Mirae Asset Knowledge Academy

What is 'Debt EquityRatio' ?

The Debt-to-Equity ratio (D/E) indicates the proportion of the company’s assets that are being financed
through debt.

Debt to Equity ratio is a long term solvency ratio that indicates the soundness of long-term financial
policies of the company

Calculation

In a general sense, the ratio is simply debt divided by equity. However, what is classified as debt can
differ depending on the interpretation used. Thus, the ratio can take on a number of forms including:

 Debt / Shareholder Equity

 Long-term Debt / Shareholder Equity
 Total Liabilities /Shareholder Equity

The most widely used ratio is Total Liabilities / Shareholder Equity

What is it Significance ?

 Debt-to-equity ratio measure of a company's ability to repay its obligations. When examining
the health of a company, it is critical to pay attention to the debt/equity ratio. If the ratio is
increasing, the company is being financed by creditors rather than from its own financial sources
which may be a dangerous trend. Lenders and investors usually prefer low debt-to-equity ratios
because their interests are better protected in the event of a business decline.

 A high debt/equity ratio generally means that a company has been aggressive in financing its
growth with debt. This can result in volatile earnings as a result of the additional interest
expense.

 If a lot of debt is used to finance increased operations, the company could potentially generate
more earnings than it would have without this outside financing. If this were to increase
earnings by a greater amount than the debt cost (interest), then the shareholders benefit as
more earnings are being spread among the same amount of shareholders. However, the cost of
this debt financing may outweigh the return that the company generates on the debt through
 investment and business activities and become too much for the company to handle. This can
lead to bankruptcy, which would leave shareholders with nothing.

 Optimal debt-to-equity ratio is considered to be about 1, i.e. liabilities = equity, but the ratio is
very industry specific because it depends on the proportion of current and non-current assets.
The more non-current the assets (as in the capital-intensive industries), the more equity is
required to finance these long term investments.

Mutual fund investments are subject to market risks, read all scheme related
documents carefully.