Debt-Equity Ratio: Meaning, Formula, Significance and Examples

The Debt-Equity ratio is a financial metric, which establishes a relationship between the total debt owed by the firm to outsiders and the funds employed by the shareholders. This ratio is used to determine the proportion of debt availed from outsiders and the funds raised by way of equity. The term debt refers to funds that have been borrowed by the company for the purpose of repayment with interest. It calculates to what extent the company is utilizing debt as compared to equity for running the business.

The Debt-Equity ratio is one of the four solvency ratios. Solvency ratios are those which measure an enterprise’s capability to meet its long-term obligations. Such measure is made using parameters, like the value of long-term debt, the assets available within the organisation, the funds invested in the firm, etc.

Generally, the lower the debt-equity ratio, the better the financial position of the company is. A debt-equity of 2:1 is considered ideal. It is noteworthy that an organisation may or may not have this ideal ratio at all points in an accounting period. But it must try its best to maintain the ideal ratio to ensure the stability of capital.

• Debt: Such obligations, which can be settled in subsequent operating cycles of the company, and not just in the one in which they were incurred, i.e., whose repayment period exceeds the period they were secured in are called debt. Examples include debentures, long-term loans from banks, capital leases, deferred income taxes, etc.
• Shareholders’ Equity: These refer to the amount invested by the shareholders/owners in the business. It comprises two types of share capital: equity as well as preference share capital and is listed on the liabilities side of the Balance Sheet under the heading ‘Equity’.

Formula:

where,

Long-term Debt = Redeemable Debentures + Interest on Debentures + Long- term loans from banks + Capital leases + Deferred income taxes

Shareholders’ Equity = Equity Share Capital + Preference Share Capital + Reserves and Surplus (Excluding fictitious Assets) + Money received against share warrants

The following three situations can arise:

• If Debt-Equity Ratio = 1, it means the debt and equity are equal in amount, and hence, the firm is highly leveraged.
• If Debt-Equity Ratio > 1, it implies that the company has high debt obligations. This implies higher chances of bankruptcy and a lower rate of return on equity.
• If Debt-Equity Ratio <1, it implies that the firm has more investments by way of equity. This reduces the uncertainty that comes with interest obligations from outsiders’ liabilities, thereby reducing the chances of bankruptcy.

Significance:

Debt-equity ratio depicts the financial leverage availed by the business and is an important measure of the solvency of the business. Creditors use the debt-equity ratio to decide whether further credit should be provided to the business or not since it helps them judge if the company is about to go bankrupt in the near future. Investors use the debt-equity ratio to determine the firm’s capacity to generate a return on investment made by them. Management uses this ratio to study the capital structure of the firm.

Illustration 1:

Compute the debt ratio of ABC Ltd. from the following Balance Sheet:

Solution:

Total Debt = 20% Debentures + Long- Term Provisions + Bank Loan 

= 1,50,000 + 1,00,000 + 3,00,000 

= ₹ 5,50,000

Equity = Share Capital + Reserves and Surplus + Profit as per Income Statement      

= 8,00,000 + 4,00,000 + 45,000

= 12,45,000

= 0.44:1

Illustration 2:

Compute the debt ratio of P Ltd. from the following information:

Total Debt 20,00,000; Capital Employed 25,00,000; Current Liabilities 4,00,000.

Solution:

Long-term Debt = Total Debt – Current Liabilities

= 20,00,000 – 4,00,000

= 16,00,000

Capital Employed = Shareholders’ Funds + Long-term Liabilities

25,00,000 = Shareholders’ Funds + 16,00,000

Shareholders’ Funds = 9,00,000

= 1.77:1