Debt-equity ratio

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Pratik Shah (Querist)
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17 August 2014 what is the importance of debt-equity ratio? how does it helps in decision making? what does it indicates?

CMA. CS. Sanjay Gupta

CMA. CS. Sanjay Gupta (Expert)
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17 August 2014 Debt-Equity ratio measures how much suppliers, lenders, creditors and obligors have committed to the company versus what the shareholders have committed. This ratio indicates the extent to which debt is covered by shareholders’ funds.

Debt-to-equity ratio is the key financial ratio and is used as a standard for judging a company's financial standing. It is also a measure of a company's ability to repay its obligations. 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. Thus, companies with high debt-to equity ratios may not be able to attract additional lending capital.

Norms and Limits
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.
For most companies the maximum acceptable debt-to-equity ratio is 1.5-2 and less. For large public companies the debt-to-equity ratio may be much more than 2, but for most small and medium companies it is not acceptable. US companies show the average debt-to-equity ratio at about 1.5 (it's typical for other countries too).
In general, a high debt-to-equity ratio indicates that a company may not be able to generate enough cash to satisfy its debt obligations. However, a low debt-to-equity ratio may also indicate that a company is not taking advantage of the increased profits that financial leverage may bring.

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