Understanding Debt to Equity Ratio

Debt to Equity Ratio shows the relationship between the company's total debt and total shareholders fund. And it indicates whether the company is financially healthy or not and the ability of a company's shareholders' equity to pay its debt obligations in a tough time. It signifies the long-term solvency position of the company. And debt to equity ratio is also known as the External-Internal Equity Ratio.

The formula to derive Debt to Equity Ratio



Total Debt - It is a sum of the company's long-term debts and short-term debts. And it is found in the company's liabilities section of the Balance Sheet.

Total Shareholders Fund - It refers to the equity amount which belongs to the company's shareholders or owners' claim on the assets after settlement of debts. It is also known as Shareholders equity, and it is found in the Balance Sheet.

Example of Debt to Equity Ratio: For the financial year, Kotak Mahindra Bank reported Total Debt as Rs. 47738.90 Cr., and Total Shareholders Fund as Rs. 84838.61 Cr.
The value as per the formula (Total Debt / Total Shareholders Fund) is calculated as (47738.90 / 84838.61) = 0.56.

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Key Highlights

The Debt to Equity Ratio is calculated by dividing total debts by the total shareholders' fund.

A low Debt to Equity Ratio below one is considered as good.

Capital-intensive companies and the Banking sector's debt to equity ratio are mostly high relative to others (like IT and Software).

The Debt to Equity ratio differs from industry to industry. For better analysis, compare the company with its industry peers.

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While looking at the Debt to Equity Ratio, the following points should also take into consideration:

Generally, a low debt to equity ratio is considered good and less risky. It indicates that the company raised more funds by shareholders' funds than debts.

A high Debt to Equity ratio indicates the company has taken a lot of debts for running the company's operations. But high ratio does not always mean a negative point. It can be due to other factors or due to its industry.

Capital-intensive companies and the Banking sector's debt to equity ratio are mostly high relative to others (like IT and Software). Capital-intensive companies need a lot of capital to invest in projects or assets, so their debts are also high. And banking and financial sectors carry a high amount of debt because they own a significant amount of fixed assets in form of branches.

If the debt to equity ratio of the company is negative this means that the shareholder's fund is negative, and it indicates that the company has more liabilities than its assets.

When the economical or other factors affect companies, then the companies with a low debt to equity ratio have a high chance to survive, and that's why a low ratio is considered less risky.

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How to use the Debt to Equity Ratio effectively

Investors should look for a lower ratio below 1. It is generally considered good.

The Debt to Equity ratio differs from industry to industry. For better analysis, compare the company with its industry peers.

Investors must check other factors while analyzing companies with a high debt-to-equity ratio. Like company has taken high debt but utilizing it efficiently and generating more revenue is a plus point. On the other hand, if the company has taken a lot of debts, but its sales or revenue is decreasing is not a good sign.

The Debt to Equity Ratio is only a part of the strategy while analyzing companies' fundamentals. For better analysis, we should check other financial metrics like Short-Term Debt to Equity, Current Ratio, Shareholder's Equity Ratio, etc.,

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