Debt to Equity (DE) Ratio

You are about to secure a key investment for your business. The presentation is ready, the numbers look good, but then the investor asks about your debt-to-equity ratio. Are you prepared to talk about it?

Understanding the debt-to-equity ratio (D/E ratio) is crucial. It is a key figure that investors and lenders often focus on because it shows how much debt your company has compared to its value. In simple terms, it tells them how much money you owe versus how much you are worth.

What is Debt to Equity Ratio?

The debt-to-equity ratio is a financial metric that shows how much a company relies on borrowed money compared to the money invested by its owners. It helps you understand the balance between two main parts of a company's funding:

Debt: The money the company has borrowed, like loans or bonds.

Equity: The money that you or other investors have invested into the company.

This ratio is usually shown as a decimal or percentage and helps show the company's financial risk and how it's funded.

Why is the debt-to-equity ratio important?

The debt-to-equity (D/E) ratio is commonly regarded as an indicator of financial risk. A higher ratio typically signals increased risk, as it implies the company is relying more on debt to finance its operations and growth. However, during periods of expansion, a higher D/E ratio can also reflect a strategic choice, facilitating accelerated growth that may not be achievable through internal funds or equity investments alone. 

Debt to Equity Ratio Formula

Below is the equation to calculate your D/E ratio:

Debt-to-Equity Ratio = Total Debt / Total Equity

To break it down further:

Total Debt: Refers to the company’s complete debt obligations, encompassing both short-term and long-term liabilities, such as bank loans, credit lines, bonds, and any other forms of borrowed capital.

Total Equity: Represents the owner’s interest in the company, including common stock, preferred stock, retained earnings, and any additional paid-in capital. 

You can find the information needed to calculate the debt-to-equity (D/E) ratio on a company's balance sheet. To get the shareholder equity, just subtract the total liabilities from the total assets listed on the balance sheet.

How to Calculate Debt to Equity Ratio?

The debt-to-equity ratio is calculated by dividing a company's total debts by the value of its shareholders' equity. This shows how much debt the company has compared to the value owned by its shareholders.

Total liabilities / Total shareholders' equity = Debt-to-equity ratio

Here is how to calculate it:

Get the numbers from the balance sheet

You need two figures: the company’s total liabilities (what it owes) and its total shareholder equity (the value owned by shareholders). You can find both on the balance sheet. Note that equity is also equal to assets minus liabilities.

Divide the numbers

To calculate the ratio, simply divide the total liabilities by the total shareholder equity. This gives you the debt-to-equity ratio.

Example:

For instance, let's say a company in India has:

Total liabilities: ₹5,00,000

Total shareholders' equity: ₹2,00,000

Using the formula for the debt-to-equity ratio:

Debt-to-equity ratio = Total liabilities/Total shareholders’ equity

Substitute the values: Debt-to-equity ratio = 5,00,000/2,00,000 = 2.5

So, the debt-to-equity ratio in this example would be 2.5.

This means that for every ₹1 of equity, the company has ₹2.5 in liabilities.

How do you fix a high debt-to-equity ratio?

If your company has too much debt compared to its equity, it's important to take action to reduce it and improve your financial health.

Increase Revenue and Equity

The best way to lower your debt-to-equity ratio is by increasing your revenue. When your company makes more money:

Pay off Debt

Use some of the extra income to pay off loans, reducing your debt.

Invest in Assets

Spend some of the money on assets that can help your business grow and make more profit, which will increase your equity.

Improve Inventory Management

Inventory can tie up a lot of money. Poor inventory management can waste resources and hurt your debt-to-equity ratio.

Optimize Inventory Levels

Make sure you have enough inventory to meet demand, but not too much that it sits unsold.

Improve Forecasting

Use sales data and trends to predict demand better and avoid overstocking or running out of stock.

Pay down loans strategically

Make a plan to pay off your debts in a smart way.

Pay high-interest debts first

Focus on paying off the loans with the highest interest rates to reduce the total interest you pay over time.

Refinance loans

Look for ways to refinance loans at lower interest rates to lower your monthly payments. Restructure debt for manageable payments. If you are having trouble paying your debts, you can consider restructuring options.

Consider alternative financing

Traditional loans are not the only option. If you have a lot of unpaid invoices, invoice financing could be a good choice.

Invoice financing

This is when you sell your unpaid invoices to a company for immediate cash. The company then collects payment from your customers. This doesn’t count as traditional debt, so it won’t directly affect your debt-to-equity ratio, making it a useful option for improving your finances.

Debt to Equity Ratio Interpretation

The debt to equity ratio helps us understand how a company is financing its operations—whether it's relying more on debt (loans) or equity (shareholder money).

High Debt to Equity Ratio

A high debt to equity ratio means the company is borrowing more money to run its business because it doesn't have enough funds. This suggests the company is at higher financial risk.

Low Debt to Equity Ratio

A low debt to equity ratio means the company has more of its own money invested in the business and doesn’t need to borrow as much. This shows that the company is in a stronger financial position.

Interpretation

A high debt to equity ratio suggests the company is depending on borrowing, which could indicate financial trouble. A low ratio shows the company is using more of its own funds, which is generally a good sign.

Misunderstanding the Interpretation

A high debt to equity ratio isn’t always bad. The ratio is calculated by dividing a company’s total debt by its equity. Some industries, like manufacturing, need to borrow more money because they require expensive equipment and facilities. On the other hand, service and tech companies usually need less capital and therefore have lower debt to equity ratios.

So, when comparing debt to equity ratios between companies, it is important to consider the industry they are in. 

Benefits of a High D/E Ratio

A high Debt-to-Equity (D/E) ratio means a company has more debt compared to its equity. Here are five benefits of having a high D/E ratio:

Leverage for Growth: Using debt allows the company to invest in new projects, expand, or improve operations without using its own funds. This can lead to faster growth.

Tax Benefits: Interest on debt is often tax-deductible, which can lower the company’s tax burden and improve overall profitability.

Increased Returns on Equity: When a company takes on debt and invests it wisely, the returns on equity can increase, leading to higher profits.

Retaining Ownership: Using debt instead of equity means the company doesn’t have to give up control or ownership by issuing more shares to raise capital.

Lower Cost of Capital: Debt is generally cheaper than equity because it doesn't require giving away ownership. This can reduce the overall cost of raising capital for the company.

Drawback of a High D/E Ratio

A high Debt-to-Equity (D/E) ratio means a company is relying more on debt than on equity (owner's money) to finance its operations. Here are 5 drawbacks of having a high D/E ratio:

Higher Risk of Default: With more debt, the company has to pay interest and repay loans. If it can't meet these payments, it may face bankruptcy or be blacklisted as a defaulter.

Increased Financial Pressure: The company must constantly manage debt payments, which can strain cash flow, especially during tough times or economic downturns.

Higher Interest Costs: Lenders may charge higher interest rates because of the risk involved, which increases the cost of borrowing for the company.

Reduced Flexibility: A company with a lot of debt may have less room to take on new projects or invest in growth because most of its resources are tied up in paying off debt.

Lower Investor Confidence: Investors may worry about the company's ability to repay its debt, leading to a drop in stock prices and making it harder to attract new investment.

Conclusion
The debt-to-equity (D/E) ratio helps investors’ spot companies that use a lot of debt, which could be risky during tough times. By comparing a company's D/E ratio with the industry average or its competitors, investors can understand how much debt the company relies on. However, a high D/E ratio doesn’t always mean the company is in trouble.