Open up a company’s balance sheet, and you will see two separate columns or categories – Assets and Liabilities. While the assets represent the company’s owned resources that have the potential of generating income, liabilities represent what the company owes.
Furthermore, the balance sheet contains a section on shareholder’s equity which shows the amount attributable to the company’s shareholders. When investing in a company, a study of the balance sheet can give you an insight into how the company is performing. You can also use various ratios to find the company’s potential. One such ratio is the debt to equity ratio. Let’s understand it.
Debt is an external source of finance for a company, while equity is an internal source of finance. The company uses both these sources of finance to fund its operations and growth. However, when estimating the financial standing of a company, its debt and equity are viewed independently and in conjunction with one another. An analysis of debt v/s equity gives you an idea of how leveraged a company is and whether your investments would bear fruit or not.
To this extent, investors use various gearing ratios to measure the company’s equity against its liabilities. The debt-to-equity ratio is one such ratio that can help investors understand how leveraged the company is. Let’s explore this ratio further.
The debt-to-equity (D/E) ratio is a metric that helps you assess the proportion of debt and assets used by a company to finance its operations.
The ratio is calculated using the following debt to equity ratio formula –
Debt to equity ratio = Total liabilities / shareholders’ equity
In the formula, the numerator and denominator are defined as follows –
For instance, the balance sheet of HDFC Bank Limited for the financial year ending on 31st March 2021 is as follows (Source: https://www.moneycontrol.com/financials/hdfcbank/balance-sheetVI/HDF01) –
Particulars | Amount (Rs. in crores rounded off) |
Equity share capital | 551 |
Reserves and surplus | 203,170 |
Deposits (liability) | 1,335,060 |
Borrowings | 135,487 |
Other liabilities and provisions | 72,602 |
From this balance sheet, the calculations would be as follows –
Total liabilities | Deposits + borrowings + other liabilities and provisions
= (1,335,060 + 135,487 + 72,602) crores = Rs.1,543,149 crores |
Shareholders’ equity | Equity share capital + reserves and surplus
= Rs. (551 + 203,170) crores = Rs.203,721 crores |
Debt to equity ratio | Total liabilities / shareholders’ equity
= Rs.1,543,149 crores / Rs.203,721 crores = 7.57 |
The ratio of debt to equity gives investors considerable insights into a company and its financial standing. Here’s what the ratio says about a company’s finances:
If the company files for bankruptcy and liquidation, its assets would be first used for paying off the debts and then the shareholders. If the debts are high, there might be nothing left for the shareholders to claim. If you have invested in such a company, you will lose your capital.
A high ratio is, thus, considered risky. If you are a risk-averse individual, investing in companies with a high ratio of debt to equity might prove counterproductive. You should, thus, look for companies that have a low ratio, i.e. below 2 or 2.5.
A high debt to equity ratio can, thus, show both a negative and a positive picture. You should, thus, assess the ratio with other metrics too to analyse if the company is a worthy investment or not.
While the debt to equity ratio can help you assess the investment risk and the company’s growth potential, its interpretation is open to debate. It has certain drawbacks that you should keep in mind when understanding the ratio.
For instance, companies in different industries can have different debt to equity ratios. This is because their sources of capital vary. For comparison purposes, the debt to equity ratio is industry-specific.
Take the instance of HDFC Bank, which was illustrated earlier. The bank’s debt to equity ratio is 7.57, which is very high compared to the accepted standard average of 2 or 2.5. Does this mean that HDFC Bank is a risky investment?
Not exactly. Take the instance of Axis Bank, another company in the same industry. Its balance sheet reads as follows:
Particulars | Amount (Rs. in crores rounded off) |
Equity share capital | 613 |
Reserves and surplus | 100,990 |
Deposits (liability) | 707,306 |
Borrowings | 142,873 |
Other liabilities and provisions | 44,336 |
Now if we calculate its debt to equity ratio, it would be done as follows –
Total liabilities | Deposits + borrowings + other liabilities and provisions
= (707,306 + 142,873 + 44,336) crores = Rs.894,515 crores |
Shareholders’ equity | Equity share capital + reserves and surplus
= Rs. (613 + 100,990) crores = Rs.101,603 crores |
Debt to equity ratio | Total liabilities / shareholders’ equity
= Rs.894,515 crores / Rs.101,603 crores = 8.80 |
Axis Bank too has a high debt to equity ratio signifying that the banking sector might experience a high debt to equity ratio. A high ratio is common for the industry and does not necessarily depict higher risk.
If you compare Axis Bank (debt to equity ratio of 8.80) and HDFC Bank (debt to equity ratio of 7.57), it would be a fair and relevant comparison. Both banks have a high debt to equity ratio compared to the standard value. However, Axis Bank tends to be slightly riskier than HDFC Bank based on its debt to equity ratio.
Another limitation is the inclusion of liabilities when calculating the ratio. Some analysts use short-term and long-term liabilities and other provisions in calculating the ratio, while others use only short and long-term liabilities. Similarly, some analysts exclude non-interest-bearing debts while others don’t. There is even ambiguity in terms of including preferred share capital in liabilities. Some experts believe that preferred stock should be included in liabilities, while others have an opposing view.
Reading the balance sheet and segregating the liabilities can also pose a problem when calculating the debt to equity ratio. Some items might look ambiguous, and getting the right value for liabilities can be challenging.
So, be careful when interpreting the ratio to avoid any ambiguity.
The bottom line
Investing your hard-earned money in a company requires a little research. You should analyse different financial ratios that depict the financial standing and stability of the company as well as its profitability. The debt to equity ratio is one such ratio that is an important parameter in assessing the leveraging opportunities that the company is using.
Leverage shows how the company uses its assets and liabilities to generate profits and can also determine the share price movements. Assessing the leverage is, thus, important and the debt to equity ratio helps you do just that. So, understand what the ratio means and how to calculate it.
Also, use the debt to equity ratio in conjunction with other important ratios when considering investing in a company.
There is no standard measure of the debt to equity ratio as the ratio depends on the company's sector. Some sectors are characterised by a high debt to equity ratio, while others have low values.
A ratio of up to 2 is considered to be a safe or healthy value, while ratios exceeding 2 or 2.5 are considered risky.
Furthermore, a very low ratio is also a bad sign as it means that the company is not utilising its debt capital to its fullest potential. It shows that while the company has debt capital, the capital is not being used for expansion and for generating profits.
Yes, the debt to equity ratio can be negative. However, a negative ratio is rare since it shows that the company is on the brink of bankruptcy. A negative debt to equity ratio is indicative of negative shareholders’ equity. It means that the company’s debts are so high that the assets are insufficient to cover them. In such situations, the company finds itself unable to continue operations and might file for bankruptcy, wherein the shareholders’ equity is used to pay off the remaining debt, which is not covered by the existing assets.
As the shareholders’ equity is used up in debt repayment, the shareholders lose a part or whole of the capital they invested in the company’s shares.
The debt to equity ratio of a company can turn negative in the following situations -
High debt to equity ratios is generally found in the banking and financial services sector. Moreover, industries that require considerable capital can also have a high debt to equity ratio. Typical instances of such companies include enterprises engaged in manufacturing aeroplanes, ships, etc.
In finance and economics, liquidation is winding up a firm and allocating its assets among claimants. It is a condition of circumstances that often develops when a business is bankrupt or unable to meet its maturing commitments. When a firm ceases operations, the remaining assets are dispersed to creditors and shareholders in order of precedence. General partners may be dissolved at any time.
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