Understanding Debt to Equity ratio

Debt to Equity ratio

Debt to Equity ratio is just what it sounds like – long-term debt divided by Shareholders’ Equity. It’s a little like the financial leverage ratio, except that it is more narrowly focused on how much long-term debt the firm has per Rupee of Equity.

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Debt to Equity = Long-Term Debt/Shareholders’ Equity

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A high debt equity ratio for a firm indicates it has been aggressively financing its growth with debt. Due to the the additional interest expenses that have to be borne by the firm, this can result in volatile earnings.

A firm could potentially generate more earnings If a lot of debt is used to finance increased operations (high debt to equity) than it would have if it did not have access to this external financing. Shareholders would benefit if this resulted in increased earnings by an amount greater than the debt cost (interest). However, the cost of this debt financing may become too much for the company to handle, especially if earnings are cyclical and volatile, and outweigh the return that the company generates on the debt.

The debt equity ratio also varies depending on the industry in which a firm operates. For example, capital-intensive industries such as auto manufacturing tend to have a debt equity ratio above 2, while software companies usually have a debt equity ratio of under 0.5.

Calculating Debt to Equity

Debt to Equity is simply calculated by dividing Total Debt (long-term debt is usually not reported separately in Annual Reports of Indian companies) divided by Shareholders’ Equity. Both Total Debt  (sum up secured and unsecured loans) and Shareholders Equity can be found in the Balance Sheet filed in the firm’s Annual Reports. Annual Reports can usually be found at the firm’s website or from SEBI EDIFAR database. Shareholders Equity is simply the difference between Total Assets and Total Liabilities – the assets that the business has generated.

Rough benchmarks for analysing a stock’s Debt to Equity