The debt/equity ratio, also known as the gearing ratio, denotes the proportion of the shareholder’s equity and the debt used to finance the company’s assets.
This ratio helps in getting an idea of the company’s debt in relation to the market price of its shares. By this, you can get a fair idea of how much debt the company is appropriating to increase its value by funding projects with the borrowed money.
It is this leveraging that might result in volatile earnings. If the debt/equity ratio for a company remains high, it implies that the company is aggressively leveraging and ambitiously financing its growth by assuming higher amounts of debt.
A higher amount of debt indicates the risk involved and thus makes the debt/equity ratio a measure of risk. Further, a higher ratio suggests greater chances of bankruptcy as a result of debt overburden and lesser growth.
Calculating the debt/equity ratio
You can easily calculate the debt/equity ratio by dividing the total liabilities of the company by its shareholders’ equity.
Debt/equity ratio = total liabilities/shareholders’ equity
It can also be calculated in percentage by multiplying the debt/equity ratio with 100.
Debt/equity ratio in percentage = (total liabilities / shareholders’ equity) *100
This can be understood using the following example:
Say company X has taken a debt of Rs250 while the shareholder’s equity is worth Rs130, then the D/E ratio will be:
Debt/equity ratio = Rs250/Rs130 = 1.923
This means for every 1 Rupee of equity, the company X holds a debt of Rs1.923.
The debt/equity ratio in percentage for company X will be 192.3%.
The debt/equity ratio of company X is on a higher side, which means the company is more aggressive towards financial leveraging. Although a higher debt/equity ratio depicts higher risk in the form of debt the company has assumed, reaching a conclusion only based on the debt/equity ratio is not right either.
There are two possible conclusions for a company with a high debt/equity ratio:
- It holds a higher risk, exacerbating problems to the extent of bankruptcy when the company is unable to recover the debt, especially since the price of equity does not increase significantly. Such a situation can land you in trouble and cause hefty investment losses to the company.
- The other situation is that it points at a higher chance of significant growth, with plans to expand the company. Keeping this possibility in mind, a higher leverage is favourable if you are expecting a significant amount of profit for your investment in the future.
Similarly, a low debt/equity ratio could result in either of the following possibilities:
- It holds lower risk, and the chances of incurring a loss on your investment are lower.
- The other scenario is that the company is not actively involved in the process of expanding the business. Thus, you cannot expect a significant profit or significant increase in the price of equity over a period of time.
- In general, the debt/equity ratio is merely an indicative measure to predict the company’s financial leveraging. The final decision would be yours after taking into account your risk appetite and the duration for which you want to stay invested.