Choosing a company to invest in
can be difficult. As an investor, you need to choose a company that will
provide you with optimal returns at minimal risk. Even seasoned investors take
several factors into account before picking a stock. One of those factors is
ratio analysis techniques. These techniques provide you with a bird’s-eye view
of the company’s financials. By gauging a company’s financial health, it will
be easier for you to make an informed decision. There are several ratios
available for you to choose from. One of them is the company’s debt-to-equity
ratio. This ratio is important to investors as it shows a company’s dependency
on its borrowings. It also indicates whether the capital structure is tilted
toward debt or equity.
To understand the debt-to-equity
ratio, you first need to know what debt and equity are.
Debt to Equity Ratio = Total Liabilities / Shareholders Equity
You may use an alternate calculation considering long-term debt instead of a company’s total debt. However, this is called the long-term debt-to-equity ratio.
Debt-to-Equity Ratio Calculations
Suppose a Company XYZ Ltd. has total liabilities of Rs 3,000 crore. It has shareholders' equity of Rs 15,000 crore. Using the Debt to Equity Ratio formula, you get:
Debt to Equity Ratio = 3,000 / 15,000 = 0.2.
Let’s have another example: Company ABC Ltd. has total liabilities of Rs 500 crore. It has shareholders’ equity of Rs 300 crore. Using the Debt to Equity Ratio formula, you get:
Debt to Equity Ratio = 500 / 300 = 1.66
Suppose the company increases the total debt by Rs 200 crore by taking a business loan. The new total debt is Rs 700 crore, and the shareholder’s equity remains at Rs 300 crore. Your Debt to Equity Ratio increases to 2.33.
The Debt to Equity Ratio tells you how much debt the company bears per Re 1 of Shareholder's Equity.
In the ideal world, every company should have more equity than debt. But that is not always the case. Most companies have either a high or low debt-equity ratio. Few companies have a debt-to-equity ratio of 1:1. This shows that the company’s finances are met equally by debt and equity. A ratio of less than 1 shows that a company’s finances are more by equity than through debt. A ratio greater than 1 shows the company’s financing is done more by debt rather than equity.
A company with a high debt-to-equity ratio has a high vulnerability, especially if a company has borrowed at a high-interest rate. Because of high debt cost, net profit will squeeze and there might not be enough funds to reinvest in the business. This might lead to bankruptcy. But not all debt-laden companies go bankrupt. Instead, some companies use their debt to invest in profitable ventures and leverage.
A company with a low debt-to-equity ratio shows lesser dependency on borrowings. But, it also indicates that the company misses out on leverage if they have an opportunity to raise the capital from the market at a reasonable cost.
Created & Posted by Pooja
Income Tax Expert at TAXAJ
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