What is Debt-to-Equity Ratio?

To pick stock from the bucket of stocks in the stock exchange we need to know the several parameters on which we could decide our investment. Let’s make this decision of yours easy. Financial Ratios are used to measure the health of any company. You can also use them to compare any two companies. This financial ratio has several parameters on which the company can be analyzed. One of the important parameters is the debt to equity ratio. Let’s get to know about the Debt-to-Equity Ratio in depth in this article. 

What are Debt and Equity?

Both ‘Debt’ and ‘Equity’ terms are used in accounting, home ownership, investing, and start-up.

Debt is something that is not owned by yourself but that is owed to someone else by you. For this example, we’re gonna talk about money but that could seriously mean anything, you can show someone a bag of chips and you’d be in debt to them. So, individuals can have debt, institutions or companies can have debt even countries and governments can have debt. In the analysis of the company, debt can be of two types short-term debt and long-term debt.

Short-term debt is for borrowing less than an equal 12 months and long-term for more than 12 months. This figure can be found on the balance sheet of the company. In the current liabilities section, we will find short-term debt and in the non-current liabilities, we find long-term debt. When we sum up these two debts of the company we get total debt or total loans or total borrowings of the company.

Equity is the money the company owns. It is generally known as shareholder’s equity. Shareholder’s equity is the money invested by the owner of the company. Equity includes the share capital or equity capital (the amount raised by the company in its IPO), reserve, and surplus (whenever the company makes a profit it shares its profit as a dividend, and the rest money is kept with them. This kept money is used for further expansion of the business). Generally, reserve and surplus are more than the equity capital of the company, Warrants (Company also raises money in the form of warrants) when all these factors are summed up then we get the total equity of the company.

Debt to Equity Calculation

Here’s the formula for calculation of Debt To Equity:

Debt To Equity = Total Liabilities / Total Equity

Calculation of Debt to Equity ratio is straightforward, it is (total Debt/shareholder Equity). 

For Example, A company has current Liabilities of Rs 50000 and Noncurrent liabilities of Rs 110000 number of common stocks is 25000 at Rs 20 each and the Preferred Stock is Rs 15000. Now to calculate Debt to Equity.

Total Debt= Current Liabilities + Non-Current Liabilities.
Total Debt= 50000 + 110000 = 160000.
Total Shareholder Equity= Common Stock + Preferred Stock
Total Shareholder Equity= 25000 *20 + 15000.
Total Shareholder Equity= 515000.
Debt to Equity= 160000/ 515000.
Debt to Equity= 0.31 

Ideally, a Debt to Equity of 2 is considered to be healthy. Now, the question may arise what if the company has more debt? This can be understood very easily in the current scenario. It is clearly understood that if the company has some loan it must be given back by the company and the company can only pay its loan back if the company is generating some profit. Now, at the time of the pandemic, all the companies were shut down and there is no operation going on in the company, as a result, there is no profit generated. Since no profit is generated and the company has to repay the loan, it goes bankrupt. Company assets will be sold to repay the loan amount and as a shareholder since the company shuts share price of the company also vanishes.

Finally, the Debt to Equity Ratio is one of the important factors for the analysis of the company. But the Debt to Equity Ratio is only useful when you compare a company’s debt with its peer of the same sector, not with a different sector.