What is 'Debt Equity Ratio' ?
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:
- Total Debt / Shareholder Equity
- Long-term Debt / Shareholder Equity
- Total Liabilities / Shareholder Equity
The most widely used ratio is Total Debt / Shareholder Equity
What is it Significance ?
· 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.
We will explain Fixed Maturity Plan’s (FMP’s) in the next edition on Mirae Asset Knowledge Academy Tutorials.
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