What is the 'Debt/Equity Ratio'
Debt/Equity (D/E) Ratio, calculated by dividing a company’s total liabilities by its stockholders' equity, is a debt ratio used to measure a company's financial leverage. The D/E ratio indicates how much debt a company is using to finance its assets relative to the value of shareholders’ equity. The formula for calculating D/E ratios is:
Debt/Equity Ratio = Total Liabilities / Shareholders' Equity
The result can be expressed either as a number or as a percentage.
The debt/equity ratio is also referred to as a risk or gearing ratio.
Debt/Equity Ratio for Corporate Fundamental Analysis
For example, company A in its fiscal year ended 2017-2018, listed its total liabilities as ₹54 Cr and total shareholders’ equity as ₹14.61 Cr. . It’s D/E ratio is, therefore, ₹54/₹14 = 3.85. For the same fiscal year, Company B recorded total liabilities of ₹27 Cr and total equity of ₹120Cr. It’s D/E ratio is ₹27/₹120 = 0.225. The ratios of both companies indicate that A is taking on more debt than B relative to the equity value.
If a lot of debt is used to finance increased operations (high debt to equity), 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 number of shareholders. However, if the cost of debt financing ends up outweighing the returns that the company generates on the debt through investment and business activities, stakeholders’ share values may take a hit. If the cost of debt becomes too much for the company to handle, it can even lead to bankruptcy, which could leave shareholders with nothing since creditors are paid first during liquidation proceedings.
Debt/Equity Ratio for Personal Finances
The Debt/Equity (D/E) ratio can be applied to personal financial statements as well, in which case it is also known as the Personal Debt/Equity Ratio. Here, “equity” refers not to the value of stakeholders’ shares but rather to the difference between the total value of an individual’s assets and the total value of his or her debt or liabilities. The formula for the personal D/E ratio, then, can be represented as:
D/E = Total Personal Debt / (Total Assets - Total Personal Debt)
The personal debt/equity ratio is often used in financing, as when an individual or small business is applying for a loan. This form of D/E essentially measures the dollar amount of debt an individual has for each dollar of equity they have. D/E is very important to a lender when considering a candidate for a loan, as it can greatly contribute to the lender’s confidence (or lack thereof) in the candidate’s financial stability.
A candidate with a high personal debt/equity ratio has a high amount of debt relative to their available equity, and will not likely instil much confidence in the lender that the candidate can repay the loan. On the other hand, a candidate with a low personal debt/equity ratio has relatively low debt, and thus poses much less risk to the lender, as the candidate would appear to have a reasonable ability to repay the loan.