Debt To Equity Ratio: Meaning, Types, Benefits & Limitations (2024)

What is Debt To Equity Ratio?

The debt-to-equity ratio is used to gauge the company’s capability to pay back its obligations. It basically shows the overall health of a particular company.
In case if the debt-to-equity ratio is higher, the company is receiving more financing by lending money subjecting to risk, and if potential debts are too high, there are chances of the company getting bankrupt during these times.
Several investors and lenders opt for a low debt-to-equity ratio because their interests are safeguarded If the business is declining.
However, the debt-to-equity ratio compares a company’s total liabilities to its shareholder equity and can be used to carry out how much leverage a company is using.
Generally, higher leverage signals to shareholders that a company or its stocks have a higher risk. However, it is tough to compare the debt-to-equity ratio across different industry groups where ideal debt amounts vary.
Investors modify the debt-to-equity ratio to focus entirely on long-term debt because the risk of long-term liabilities are different compared to short-term debts and payables.

Debt to Equity Ratio Interpretation

Interpretation

A high debt-to-equity ratio indicates that a company is borrowing more capital from the market to fund its operations, while a low debt-to-equity ratio means that the company is utilizing its assets and borrowing less money from the market.
Capital industries generally have a higher debt-to-equity ratio. In contrast, industries packed with services and technology have lower capital and growth needs on a comparative basis and therefore may have a lower DE.
Now by definition, you can come to the verdict and understand that a high debt-to-equity ratio is bad for a company and is viewed negatively by several analysts.

How is Debt-To-Equity Ratio Calculated?

The debt ratio formula is calculated by dividing a company’s total liabilities by shareholder’s equity. The formula is like this:
Debt-to-equity ratio = Total Liabilities/Shareholder’s Equity
The total liabilities include short-term debts, long-term debts, and fixed payments obligations.

How Does a Debt-to-Equity Ratio Work?

A high debt-to-equity ratio comes with high risk. If the ratio is high, it means that the company is lending capital from others to finance its growth. As a result, lenders and Investors often lean towards the company which has a lower debt-to-equity ratio.
However, the debt-to-equity ratio is compared to the data executed from other financial years. Therefore, if the debt-to-equity ratio shows a sudden increase, it means that the company has a growth strategy that is aggressively funding through debt.
The ratio should be compared with the average ratios to avoid confusion. Generally, companies with intensive capital tend to have a higher debt-to-equity ratio than service firms.

Benefits of High Debt-to-Equity Ratio

1. A high-debt to equity ratio signifies that a firm can fulfil debt obligations through its cash flow and leverage it to increase equity returns and strategic growth.
2. The cost of debt is lower than the cost of equity, and therefore increasing the debt-to-equity ratio up to a specific point can decrease a firm’s weighted average cost of capital (WACC).
3. Using more debts increases the company’s return on equity (ROE). However, the equity amount is smaller, and returns on equity is higher if the debt is used instead of equity.

Limitations of Debt-To-Equity Ratio

1. A debt-to-equity ratio of 1 is considered to be equal, i.e. total liabilities = shareholder’s equity. This ratio depends on the proportion of current and noncurrent assets because it is very industry-specific. It is said that companies with intensive capital will have a higher DE than service companies.
2. The maximum acceptable debt-to-equity ratio for more companies is between 1.5-2 or less. Large companies having a value higher than 2 of the debt-to-equity ratio is acceptable.
3. A debt-to-equity ratio indicates that a company may not be able to generate enough cash to satisfy its debt obligations. However, a company with a low debt-to-equity ratio means that a company is grabbing the advantage of the increased profit that financial leverage may bring.

What are the Risks Involved in High-Debt-to Equity Ratio?

There are two major risks involved in a high debt-to-equity ratio.
1. If the company has a high debt-to-equity ratio, any losses incurred will be compounded, and the company will find it difficult to pay back its debt.
2. If the debt-to-equity ratio is too high, there will be a sudden increase in the borrowing cost and the cost of equity. Also, the company’s weighted average cost of capital WACC will get too high, driving down its share price.

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