Understanding Financial Fundamentals through Debt to Equity Ratio

CA Anurag Sharma | Last updated: 11 February 2023

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The Debt to Equity (DE) Ratio is a crucial financial metric used to assess a company's financial health. It's calculated by dividing total liabilities by total shareholder's funds. A high ratio suggests higher risk due to reliance on borrowings, while a low ratio indicates a greater dependence on the company's own funds. While there's no single ideal ratio, a DE ratio of 2 is often considered satisfactory, meaning the company has twice as much debt as equity.

Continuing my series of understanding Financial Parameters, the first two being:

Debt to Equity Ratio: Understand Company Finances

Here's the third most important financial parameter: Debt to Equity Ratio

Formula for Debt to Equity Ratio also known as DE Ratio is Total Liabilities divided by Total Shareholder's Funds.

Shareholders funds = Total Assets - Total Liabilities
or, Share Capital + Retained Earnings + Other Reserves
Total Liabilities = Short term + Long term liabilities

Debt to Equity is one of the basic fundamentals to assess the financial position of a company. It is not only used by investors for evaluating the company but it is also used by Banks or other financial institutions before granting loans or cash credits.

High debt-to-equity ratio means that investing in the company can be risky because the company is more dependent on borrowings while a low debt-to-equity ratio means that the company is more dependent on its own funds.

There is no ideal debt to Equity ratio but a debt to equity ratio of 2 is considered satisfactory as per industry standards. It means that the company has Rs.2 borrowings again Re.1 of its own funds.

High Debt to Equity ratio also means that the company may not be able to repay its debts. However, manufacturing industries tend to have higher Debt to Equity Ratios as they are more capital-intensive and their manufacturing needs can be fulfilled by outside borrowings compared to service industries. Therefore, one needs to consider industry parameters too before analyzing a company through Debt to Equity Ratio.