The assets of an enterprise may be financed entirely by the owners’ funds or by an appropriate mix of owners’ funds (equity) and outsiders’ fund (debt). Debt -equity ratio indicates to what extent the assets of an entity are financed by debt. It shows the relationship between the owners’ claim and outsiders’ claim over the assets of an entity. A company may prefer to use debt component because interest is an eligible expense for computation of tax which in turn improves earning per share.
How to Calculate Debt-Equity Ratio
Debt-equity ratio can be calculated as below:
Debt-equity ratio= Total Outsiders’ Funds/ Owners’ (Shareholders’) Funds
Total Outsiders’ Funds: Here, all the liabilities to outsiders, whether long term or short term are taken into consideration.
Owners’ (Shareholders’) Funds: Shareholders’ funds can be computed by subtracting the liabilities from the assets of the company. It represents the owners’ stake over the assets of the company after all the company’s liabilities have been paid for.
Debt-equity ratio can also be calculated excluding the current liabilities from the total outsiders’ funds considering the fact that current liabilities do not require long term commitment. In scenario such this, the debt-equity ratio would be as follows:
Debt-equity ratio= Long term debt/ Owners’ (Shareholders’) Funds
Interpretation of Debt-Equity Ratio
A debt- equity ratio of greater than 1 indicates that the outsiders’ claim is greater than owners’ claim over the assets of the firm. On the other hand, a debt- equity ratio of less than 1 indicates that the outsiders’ claim is less than owners’ claim over the assets of the firm. A high debt-equity ratio indicates that the company is using more borrowed funds to finance its assets. Conversely, a low debt-equity ratio indicates that the company is using more shareholders’ funds than borrowed funds. A debt-equity ratio of 3 means that the company has used 3 units of debt-component against each unit of owned capital.
It is essential for a company to use proper mix of debt and equity. In general, debt is cheaper than equity and an appropriate mix of debt and equity can increase the shareholder value. However, higher accumulation of debt increases the financial risk of the equity shareholders and due to this cost of equity further increases after a certain point. Therefore, at this stage of capital structure, the increased cost of equity cancels out the advantage of the cheaper debt. Moreover, at this point on account of the increased financial risk, cost of debt may also rise. Therefore, a high debt-equity ratio may not be considered good.
What is a Good Debt-Equity Ratio
The appropriate debt-equity ratio may be different from industry to industry. Some industries may experience a higher debt-equity ratio in common while some industries may experience a lower debt-equity ratio in normal course. A debt-equity ratio of 1.5:1 may be considered satisfactory depending on the nature of the industry, location of the unit, size of the unit etc. In case of large-size capital intensive unit such as a manufacturer, a higher debt-equity ratio e.g. 3 or more may be acceptable. On the other hand, in case of a unit in the service sector which requires less amount of capital, a lower debt-equity ratio may be desirable.
Conclusion
Debt-equity ratio is a leverage ratio which reflects the financial health of a company. By comparing total debt to total equity, debt-equity ratio reflects how much a company’s assets are financed by debt component vis-à-vis owners’ fund. In general, a high debt-equity ratio indicates that the company has relied more on debt component in comparison to shareholders’ funds. Creditors and investors may find companies with high debt-equity ratio riskier than companies with low debt-equity ratio. The reason behind it is that owners’ have not invested in the company as much as the creditors have. Further, debt financing requires debt servicing failing which a company may go for liquidation. A low debt-equity ratio indicates a comparatively financially stable business. Debt-equity ratio is a good metric to identify the composition of owners’ capital and outsiders’ capital of a company.