Debt to Equity Ratio

Expanding a business requires capital. When companies expand, they need capital for several tasks (i.e. hiring employees, expanding operations, launching new product).

There are two ways to raise funds for business : debt and equity

By debt, companies makes an agreement to raise capital under the condition that it is to be paid back at a later date, usually with interest.

By equity, companies sell an amount of their ownership to raise capital.

Debt to equity ratio is a solvency ratio that measures company's financial leverage. It is a measure of the degree to which a company is financing its operations through debt versus wholly-owned funds. DE ratio shows the risk of creditor's investment. Simply, it gives the state of company's money payable to company's money in hand. 

WHAT IS DEBT?

In commercial terms, company's money payable is known as debt. Debt is nothing but loan taken by company to either expand (increase production capacity) or to acquire assets (i.e. land, acquiring any company, new tools and machinery etc). There may be various reasons for debt. 

In a balance sheet, debt is the sum of current and non-current liabilities.

WHAT IS EQUITY?

In case of debt to equity ratio, equity would be understood as total money with the company.

In a balance sheet, total equity is the sum of shareholder's fund, reserve and surplus, and share capital.

How to calculate debt to equity ratio?

Many stock screening website like Moneycontrol, Screener, Ticker, Ticker tape, IIFL do give such ratios directly, and we need not calculate it but for knowledge purpose let's take an example.

Corporation X has 3 Cr as equity (money with the company) and 2.8 Cr as loans (company's money payable/liability)which was borrowed for the purpose of expansion. On dividing total debt by equity we get DE ratio of 0.94. 

All the above-mentioned terminologies like liability, equity are available in a company's balance sheet.

UNDERSTANDING D/E RATIO 

If we say that Igarashi Motors Limited witnessed a debt to equity ratio of 0.28 and Supreme industries limited had a debt to equity of 0.19.

What an investor should understand from such statements?

Debt to equity < 1( less than 1)suggest that company has more money in hand then its money payable to lenders.

Debt to equity = 1( equal to 1) suggest that company's money in hand is equal to company's money payable to its creditors. 

Debt to equity > 1 (greater than 1) suggest that company has more money payable to its lenders/creditors then money with the company.

What is a good debt to equity ratio?

DE ratio < 1 is considered ideal (best) debt to equity ratio. However, DE ratio ranging between 1 - 1.5 is also considered good.

Hence good debt to equity ratio ranges from (0-1.5).

High debt to equity ratio shows that company uses debt to finance its growth. Debt to equity close to zero shows that company does not rely on debt for growth. 

IMPORTANCE / SIGNIFICANCE OF DEBT TO EQUITY RATIO

• Debt to equity ratio is important tool to examine the real worth of a company (i.e.. money payable to creditors over its money in hand.)
• High debt to equity ratio indicates low liquidity. It means that there are high chances of company going bankrupt. We can also say that company finances its operation from debt, indicating it's dependence on creditors for financing. Such conditions indicate nearing bankruptcy.
• High debt to equity indicates high debt. due to high debt, significant amount of profit to be paid as interest and hence lowering shareholder's earning. Therefore, debt to equity ratio also helps understand shareholder's earning.
• Debt to equity ratio helps evaluate small business for loan approval. This ratio shows how easily can the company pay off its loan installment.
• Debt to equity ratio informs the business officials when and how they can take risk and grow their company.  
• Debt to equity ratio helps management in decision making in order to reach ideal debt to equity ratio. It helps management to understand how well the company is competing with its peer.

LIMITATIONS OF DEBT TO EQUITY RATIO

Debt to equity ratio may fool you in this way!
Low Debt to equity ratio may be result of company not appropriately financing/utilizing its asset with the debt obtained. It would result in low returns even if the debt to equity is low. 

Let's take a situation when we compare Tata Motors and Mind Tree Limited. Tata Motors have a debt to equity of 1.14 whereas Mind Tree Limited with DE ratio of 0.0. This shows that Mind Tree is much better investment than Tata Motors from this point of view. 

but wait a minute

We can't compare DE ratio of Tata Motors with Mind Tree Limited since one company belongs to auto sector and the other belongs to IT sector. Automotive business is capital intensive business(business that require large amount of capital investment). Therefore, it is obvious that Tata Motors will have a high debt to equity ratio as compared to Mindtree. Thus, we should not compare debt to equity of companies belonging to different sectors. 

LONG TERM DEBT TO EQUITY RATIO (LTDE)

It is a debt to equity ratio where only long term debt of a company is considered. There are two types of debt on a company Long-term debt : Debt to be repaid in more than 12 months.

Short-term date : Debt to be repaid within 12 months.

In corporate world, long term debt is considered better than short term debt. 

In the following, both companies have same debt to equity ratio. It makes it difficult to make an investment decision.

In such cases long-term debt to equity ratio comes into play. Companies with more long term debt are considered stable comparatively to companies with more short-term debt. 

When two companies have same debt to equity ratio, the Long Term Debt to Equity ratio (LTDE ratio) plays an important role in making a difference. It can be calculated by dividing the long term debt/ liabilities of a company to its total equity. 

Hence in the above case, company A would be a better investment.

NEGATIVE DEBT TO EQUITY RATIO

Circumstances occur when company's debt installments are greater than company's Return On Investment (ROI). 

To understand following situation, let us consider an example of company C.

Company C has monthly debt installment of Rs 1,18,950 but the asset that was financed through debt made Rs 99,000 monthly. 

Therefore, company had a negative cash flow of Rs (-19,950) monthly.

In this case, company did not make any money instead it lost Rs 19,950 each month.

Hence, for businesses it is very important to make money from Debt financed assets. 

TOP 10 DEBT FREE COMPANIES IN INDIA

Hindustan Unilever Limited: Hindustan Unilever Limited is the Indian subsidiary of Unilever which is a British-Dutch multinational company. Its products include foods, beverages, cleaning agents, personal care products, water purifiers and Fast-moving consumer goods.

Castrol India:Castrol India Limited is an automotive and industrial lubricant manufacturing company. Castrol India is the 2nd largest manufacturer of automotive and industrial lubricants in the Indian lubricant market. Its part of Castrol Limited UK.

Colgate-Palmolive: Colgate-Palmolive Company is an American multinational consumer products company headquartered on Park Avenue in Midtown Manhattan, New York City. It specializes in the production, distribution and provision of household, health care, personal care and veterinary products.

Bosch: In India, Bosch is a leading supplier of technology and services in the areas of Mobility Solutions, Industrial Technology, Consumer Goods, and Energy and Building Technology.

Swaraj Engines:Swaraj Engines Ltd. (SEL)is into manufacturing and supplying of diesel Engines in the range of 22 HP to above 65 HP. 

Foseco India: Foseco India Limited is the Foundry Technologies Division of Vesuvius plc, a company that offers products, such as feeding aids, filtration, ferrous and non-ferrous metal treatment, binders, coatings, molten metal transfer and molding materials.

Bharat Electronics Ltd: is an Indian state-owned aerospace and defence company with about nine factories, and several regional offices in India. is owned by the Indian government and primarily manufactures advanced electronic products for the Indian Armed Forces.

HDFC Life-Insurance: HDFC Life is one of the leading life insurance companies in India. that offers a range of individual and group insurance solutions that meet various needs such as Protection, Pension, Savings & Investment, Health, Child and Women's plans.

GM Breweries: is engaged in the activities of manufacturing and marketing of Alcoholic Beverages; such as Country Liquor (CL) and Indian made Foreign Liquor (IMFL).

Bajaj Holdings: Bajaj Holdings & Investment Ltd (BHIL) (formerly known as Bajaj Auto Ltd) is an India-based company. The company is acting as a primary investment company and focusing on new business opportunities.