How To Calculate Debt Equity Ratio

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Debt to equity ratio is a long term solvency ratio that indicates the stability of long-term financial policies of a company. It compares a company’s total debts to total equity. It shows the portion of investment in company’s assets by creditors and investors.

A high debt to equity ratio indicates that financing from creditors (bank loans) is used more as compared to financing by investor (shareholders).

Formula:

Debt to equity ratio is calculated as follows:-.

               Debt Equity Ratio=          Total Outside Liabilities

                                                                      Total Assets    

Total Outside liabilities includes the total of current and long term liabilities

Total stockholders’ equity includes total of Share capital , Free reserve & Share Premium etc.

Ideal Debt Equity Ratio 1:1 is normally considered satisfactory for the most of Company.

Example: XYZ Ltd has the following liabilities as at 31st December 2016:

Amt in crores Amt in crores
 
Equity Share Holder’s Fund
Share Capital 200
Reserve & Surplus 55       255
Current Liabilities
Trade payables 117
Income tax payables 85 202
Non Current Liabilities
Bank Loan 50
Deferred tax payable 30 80

 

Debts Equity Ratio

 

=

         Total Liabilities  

=

282  

=

 

1.106

Total Shareholder’s Fund 255

Explanation:-It indicates that lenders contribution in assets is more than Shareholders. In other words, we can say relation between the portions of company’s assets financed by lenders is more than financed by shareholders.

Significance and interpretation:

A ratio of 1 (or 1: 1) means that business assets are financed by shareholder and by outside liabilities in equal proportion.

A less than 1 ratio indicates that the portion of assets financed by stakeholders is greater than the portion of assets financed by all outside liabilities and a greater than 1 ratio indicates the vice versa.

Investors/ Lenders/ Financial Institutions like or prefer a organization with low debt equity ratio because a low DE Ratio indicates good financial strength of the entity.

But, if debts are available at a low cost than companies return on investment then taking debts may be a beneficial situation.

Whenver Bank or Fianancial Institutions   for evaluating any project for take note of current DE ratio as well as future/projected  DE ratio.After project and funding decision implementation

Ideal DE Ratio varies from industries to industries .Ideal for one industry may be bad for another.

Normally bank are comfortable for DE ratio equal to 2:1.However its has been seen practically that banks financial institution and non banking financial institution have financed projects with debt equity ratio upto 5:1. But a higher DE ratio affects the financially decision and result into lesser financial and higher intrest.

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