Debt to Equity Ratio is a financial ratio used by investors to judge the financial position of a company.
D/E ratio is also called the gearing ratio.
Maintaining an ideal level of gearing ratio is important for the survival of a company during an economic down return or recession.
D/E ratio in simple words measures how much debt a company has borrowed against each $1 of shareholders equity.
Formula and its application.
If a company has 500cr of debt & 1000cr of equity on its balance sheet. This results in a debt/equity that will be 0.5:1, which is considered good.
Ready made ratio
But in a few places, the total liabilities part of the formula includes short-term debt. So before using it check whether total liabilities include short-term debt or not.
For purpose of conservatism considering short-term debt along with the long term debt is fine.
But being consistent with the approach is important while comparing companies otherwise the observation will be incorrect.
Debt to equity ratio in action?
D/E ratio is used for comparing the companies in the same industry. The ideal debt/equity ratio is different for different companies.
Generally, the Ideal debt to equity ratio is 2:1.
This means that a company should have at least $1 of equity for every $2 of borrowed money.
For Eg:- IT firms like Infosys Ltd & Wipro Ltd will have a lower D/E ratio as it requires lesser capital to operate. Whereas Power sector companies will have a higher d/e ratio as it is a capital incentive sector.
Debt/Equity ratio with other factors.
D/E ratio should be analyzed with other factors like the type of loans, interest rate, operating cash flow of the company, etc.
For Eg:- A company may have issued convertible bonds that have a lower interest rate, but which will later result in dilution of equity.
D/E ratio should be analyzed with operating cash flow.
Because a company may have lower debt as compared to other players in the sector, but it may not have sufficient cash flow to it pay off.
Recommend Read : Learn about all financial ratios
Companies operating in a cyclical industry may have higher or lower gearing ratio at different points of time during its existence and the stages in the cycle.
So understanding the sector cycle along with debt/equity ratio is important.
Cyclical industries include Real Estate, NBFC’s, commodity industries like steel, copper, cement, etc.
For Eg:- In the start, a commodity’s demand is less thus there is no need for additional capital. But as the commodity’s demand starts raising companies start leveraging their balance sheet.
This results in oversupply and reduction in demand, therefore turning a lower debt sector into a higher debt sector.
- Calculated to check whether a company can survive a recession.
- A Higher D/E ratio is considered a red flag
- Used for comparing firms in the same industry.
- The ideal D/E ratio is 2:1.
- An ideal gearing ratio is different for different industries or sectors.
- Check the debt/equity ratio along with other factors.