The debt to equity ratio is one of the leverage ratios which calculates the total debt to the shareholders’ equity.
Debt to Equity Ratio= Total Debt/ Shareholders Equity
Interpretation of Equity and Debt
When a person wants to start a business, he needs funds. These funds can come from him or their family and someone else. When he is putting his money in place, it is called equity, and if the money coming from some other sources like friends, relatives, banks, etc. will be called equity or debt depending upon what they are demanding in return. If they require a fixed rate of interest and have nothing to do with the business, then the funds are called debt funds. If they don’t want a fixed rate of interest and want to become a part of the company, become shareholders, and enjoy the profits, then the funds are called equity.
Is debt good or bad for the business? Having a little bit of debt is not bad for the business. The Debt to Equity ratio should always be less than one and at the most 2:1. In simple words, the company’s shareholders’ equity should be greater than the company’s debt. If the company’s debt is more outstanding than the shareholders’ equity, one needs to check why this is so. Also, check whether the company will repay its debt immediately or not; if its debt is lower than the shareholders’ equity, then fine. But if the company’s debt is more than the shareholders’ equity, you should be alert and stay away from such companies.
Interpretation of Return on Equity (ROE)
Return on Equity (ROE) measures the profitability earned by a company on shareholders’ funds. The higher the ROE, the better it is for the shareholders. However, make sure to check the debt levels along with this.
Return on Equity (ROE)= Profit After Tax (PAT)/ Shareholders equity
Let’s look at two companies to see how much impact debt makes on equity return. Let’s say that company A and company B need capital of Rs. 1,00,000 crore. Company A raised Rs. 50000 crore from equity and Rs. 50000 crore from debt, and Company B raised Rs. 100000 crore from equity.
(₹ million)
| Company A | Company B | |
| Equity | 50000 | 100000 |
| Debt | 50000 | — |
| Assuming debt raised at the rate of 14% | ||
| Profit | 20000 | 20000 |
| Interest | 7000 | — |
| Assuming no taxes paid | ||
| PAT | 13000 | 20000 |
| ROE (in %) | 26% | 20% |
Return on Equity (ROE) for company A
= PAT/Shareholders equity * 100
= 13000/50000 * 100
= 26%
Return on Equity (ROE) for company B
= PAT/Shareholders equity * 100
= 20000/100000 * 100
= 20%
In both cases, business profitability remains the same. Still, company B’s Return on equity is less than company A as Return on equity is inversely proportional to Shareholders’ equity.
Therefore a little bit of debt is fair. The problem will arise when the profitability of the business goes down.
Again let’s look at these companies where the profitability goes down. We will see how the debt to equity composition impacts the ROE.
(₹ million)
| Company A | Company B | |
| Equity | 50000 | 100000 |
| Debt | 50000 | — |
| Assuming debt raised at the rate of 14% | ||
| Profit | 5000 | 5000 |
| Interest | 7000 | — |
| Assuming no taxes paid | ||
| PAT | (2000) | 5000 |
| ROE (in %) | (4)% | 5% |
The Returns on equity of company A is negative 4%. From the above example, if businesses and sales go down somehow, then the companies profitability will also fall. The companies have to pay interest on their debt, and the bank will not waive it off. In such a situation, the companies with high Debt to Equity ratio will be badly affected, the debt will compound their losses, and they could not service their debt.
Conclusion
A low debt to equity ratio is favourable from an investment point of view. It is less risky in increasing interest rates and attracts more capital for further investment and business expansion. Investors and analysts want companies to use debt smartly to fund their businesses.
Also Read: Price/Earnings to Growth ratio
Also Read: Price to Earnings ratio