Analyzing the financial health of a business is a crucial practise not only for the owners of the business entity but also for investors and vendors. It provides the details of the financial standing of the business further helps in making sound financial decisions. Such fundamental analysis can be done based on many ratios and parameters used by experts to decide the optimum level of resources or the efficiency of the business to generate profit, etc.
The debt-equity ratio is part of the financial ratios that are reviewed by various entities like owners, lenders, investors, etc. to know the true picture of the financial health of the business entity.
Given below are the meaning and a few details of the debt-equity ratio of an organization.
What is the debt equity ratio?
A company or a business organization is made of essentially two types of finances namely internal finance and external finance. The internal finances of the business are essentially the owner’s funds or the equity of the business. On the other hand, external finance is the finances secured from external sources like lenders, investors, etc. Such finance forms the debt portion of the business. Another difference here is that debt is paid back, the equity portion is not paid back
A debt-equity ratio is the ratio of the total debt or the external funds of the business entity to the total owner’s funds or internal funds of the business entity. This ratio is often used by experts to know about the ability of the business to repay its dues.
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What is the formula for the debt-equity ratio?
The mathematical formula for the debt-equity ratio is given below.
Debt equity ratio = Total debt of the business entity / Total equity of the business entity.
In the above ratio, the total debt includes the long term debt of the business and the debentures. The total equity on the other hand includes the owner’s funds i.e., the share capital and the reserves and surplus of the company.
Many experts believe the ideal debt-equity ratio is 1:1, i.e., equal debt and equity components in the business organisation. However, the ideal debt-equity ratio for every industry is different based on their capital requirements and risk profile.
What is the significance of the debt-equity ratio?
The debt-equity ratio is used to measure the ability of the business organization to meet its external commitments. When the debt-equity ratio is 1:1, it implies that the business has an equal portion of the equity to meet its debt obligations. A debt-equity ratio of 2:1 or higher implies that the debt of the company is on the higher side than the equity portion.
In common terms, it implies that the business has Rs. 2 of debt for every Re. 1 in equity. Such entities are considered to be high-risk companies or high-growth companies depending on the overall financial position of the company. Generally, industries requiring heavy capital investment have a higher debt-equity ratio than service-oriented industries.
When the debt-equity ratio is lower than 1 or negative, it implies that either the company has enough funds to finance its goals and eventual growth or the company has not realized its full potential and is in the nascent stage of growth. On the other hand, it can also imply that the company pays higher interest on its debt while receiving lower returns on its equity and in turn reflects the negative net worth of the company.
Hence, it is important to look at the debt-equity ratio in totality with other financial ratios and the complete financials of the company to get its true financial position.
What are the benefits of a high debt-equity ratio?
Having a higher debt-equity ratio has many benefits when viewed in line with the healthy financials of the business entity. Some of such benefits are mentioned below.
- A higher debt-equity ratio means that the owners have better control over their business with limited capital and can enjoy a higher return on equity (ROE).
- The cost of debt is usually lower than the cost of equity. So having more debt than equity reduces the overall weighted average cost of capital (WACC)
- A higher debt-equity ratio shows that the organization is using the debt to leverage its capital and use the resources efficiently.
What are the limitations of a higher debt-equity ratio?
As we discussed the benefits of a higher debt-equity ratio, there are also some limitations, These limitations are discussed below.
- A higher debt-equity ratio can imply that the lenders eventually have a greater say or interference in the day to day operations of the organization
- An already higher debt-equity ratio decreases the potential for getting further funds through external sources as lenders will consider such businesses to be a high-risk candidate for further debt.
- The obvious disadvantage of having a higher debt-equity ratio implies a higher outflow towards interest payments which directly impacts the profitability of the business.
Conclusion
A debt-equity ratio is an important yardstick to measure the financial health of the business. It is an important financial ratio reviewed by industry experts, analysts, investors and shareholders to make sound investment decisions. The optimum debt-equity ratio varies from industry to industry and depends on various other factors. However, it is advisable to not look at the debt-equity ratio on a standalone basis to get the correct picture of the business.
FAQs
Some of the common factors in determining the optimum debt-equity ratio are,
1. The nature of the industry (capital intensive or not)
2. The stage of the business (new stage, growth stage or stability)
3. The risk involved in the business
No. Short term debts are not included in determining the debt-equity ratio.
A debt-equity ratio of 1:1 implies that the business has an equal portion of debt and equity to fund its assets.
Having a low debt-equity ratio implies either of the following,
1. The business has sufficient equity capital to fund its current projects and possible future growth prospects.
2. The business has not utilized its full potential and has possible scope for increasing additional capacity.
3. The lower debt-equity ratio can also imply a negative net worth of the business.
Some other financial ratios that have to be reviewed along with the debt-equity ratio are current ratio, quick ratio, debt coverage ratio, return on equity, etc.
