First let’s understand the aspects required to calculate this ratio
Debt: In simple terms, debt means borrowings or loans taken by the company. Details regarding debts can be found in the balance sheet of the company. Debt can be classified into 2 parts:
- Short Term
- Debts which have maturity period of up to 12 months
- Can be found under Current Liabilities section of the balance sheet
- Long Term
- Debts having maturity period of more than 12 months
- Can be found under Non-Current Liabilities section of the balance sheet
Addition of the above 2 parts constitutes the final debt portion
Equity: Details regarding the equity values too can be found in the balance sheet. There are 3 types of equities:
- Share Capital (Equity Capital)
- This is the amount that the company has raised during the IPO
- Can be calculated by multiplying the price of per share in the IPO multiplied by the number of shares issued
- Reserves & Surplus
- Amount kept aside by the company for expansion and contingencies out of their profits after giving out dividends
- Is part of the equity shareholder money
- Securities that give the holder the right, but not the compulsion, to buy a certain number of securities (usually the issuer’s common stock) at a certain price before a certain time
Addition of all the above 3 will give the equity potion amount.
Debt to Equity Ratio = Total Debt ÷ Total Equity
where, Total Debt = Short term borrowings + Long term borrowings & Total Equity = Share Capital + Reserves & Surplus + Warrants
How to use the Debt to Equity Ratio?
While using Debt to Equity ratio of comparison, it is important to note that companies chosen should be of the same sector.
For Example, you cannot compare FMCG companies with Steel companies. If you want to compare HUL you can compare it with companies of the same sector, like Godrej Consumers. HUL cannot be compared with Tata Steel.
Also, this is not the only ratio to be looked at while comparing the companies. But yes, it is one of the important ones. It definitely gives information on how things are happening in a particular sector.
Now let’s compare some companies for example
|Debt to Equity Ratio||2.23||1.6|
In comparison with Idea, Bharti Airtel’s Debt to Equity ratio is looking good
Using Debt to Equity Ratio with other ratios
If a company’s Return on Capital Employed is more than the cost of debt, then high debt to equity ratio can also be useful for the company. This means that the company is borrowing at lesser costs and are getting returns with higher yields.
Usually, this is a good sign for the company, but generally when debt portion keeps going up, the company cannot service(handle) the debt properly. It means that the return on capital employed is less than the cost of capital and that is what keeps on reducing the reserves and surplus of that company.
Examples of this type of companies:
- Reliance Communications (RCom)
- Debt to Equity Ratio = 16.97
- Because of such high ratio this company is currently facing lots of trouble
- IL&FS (transport division)
- Debt to Equity Ratio = 4.39
‘0’ Debt to Equity Ratio
Some companies even have ‘0’ debt to equity ratio. For example, some 2-wheeler auto companies like Bajaj Auto, Hero MotoCorp, Eicher Motors.
It means that they don’t have any debt and manage the company on their equity and reserves & surplus smoothly. They don’t have any pressures of liabilities. This tell us that these are very well managed companies.