When assessing a company’s financial health, the debt to equity ratio, also called the risk ratio or gearing ratio, offers valuable insight. This leverage metric compares a company’s total debt and liabilities to its shareholders’ equity, showing how much of its operations are funded by borrowing versus owned capital.
It is a simple yet powerful way to understand the financial stability and risk of a company.
What Is the Debt to Equity Ratio?
The debt-to-equity ratio (D/E ratio) compares a company’s total liabilities to its shareholders’ equity, showing how much debt is used to finance its assets relative to the capital provided by its owners.
How Does Debt to Equity Ratio Work?
Debt to Equity Ratio = Total Liabilities ÷ Shareholders’ Equity
Total Liabilities
Total Liabilities= Current Liabilities+Long−Term Liabilities
- Current Liabilities:Short-term debts (due in < 1 year). E.g., Accounts Payable, Short-Term Loans.
- Long-Term Liabilities:Long-term debts (due in > 1 year). E.g., Bonds Payable, Long-Term Loans.
Shareholders’ Equity
Shareholders’ Equity= Paid−in Capital+Retained Earnings−Treasury Stock+AOCI
- Paid-in Capital:Money from shareholders for stock
- Retained Earnings:Accumulated profits
- Treasury Stock:Repurchased company stock
- AOCI:Unrealised gains and losses
Example and Calculation
Suppose a company has:
- Total Liabilities= ₹40 lakh
- Shareholders’ Equity= ₹20 lakh
D/E Ratio = ₹40,00,000 ÷ ₹20,00,000 = 2
Interpretation
A ratio of 2 means the company uses ₹2 of borrowed funds for every ₹1 of shareholders’ money. This suggests a higher financial risk since a significant portion of operations is funded through debt.
NOTE: Creditors, such as lenders and debenture holders, are always prioritised over shareholders when repayments are made. This means debts are cleared before shareholders receive any claim on the company’s assets.
Debt to Equity Ratio Interpretation
| Aspect | High D/E Ratio | Low D/E Ratio |
| Risk Profile | Higher financial risk | Lower financial risk |
| Funding Source | Relies on debt | Relies on equity |
| Growth Potential | Can leverage growth | Slower, more stable growth |
| Impact on Investors | Higher risk for shareholders | Safer for lenders and investors |
| Creditor View | Less favourable | More favourable |
Key Takeaways on Debt to Equity Ratio
- Debt-to-equity ratio measures a company’s ability to meet its financial obligations
- A higher ratio signals greater reliance on debt, which can increase bankruptcy risk
- Lenders and investors often prefer a lower ratio for better protection during downturns
- High leverage usually means higher risk for shareholders
- Ideal debt levels vary across industries, making cross-sector comparisons challenging
- Some investors calculate the ratio using only long-term debt to better assess financial risk
Conclusion
The debt-to-equity ratio is like a quick health check for a company’s finances. It shows whether the business is leaning more on borrowed money or its own funds to run operations.
A high ratio can boost growth through leverage but also makes the company more vulnerable if things go wrong. A low ratio signals stability but might mean slower growth. Since every industry works differently, it’s best to compare companies within the same sector.
Knowing how to read this ratio can help you spot strong businesses, avoid risky ones, and make smarter investment choices.
FAQs
What is a good debt to equity ratio for a company?
A ratio around 1 is often considered healthy, but the ideal level depends on the industry. Capital-intensive sectors may sustain higher ratios, while service-based businesses usually operate with lower ones.
Why do investors prefer a lower debt to equity ratio?
A lower ratio means the company relies more on its own capital and less on borrowed funds, reducing financial risk and improving stability during economic downturns.
Can a high debt to equity ratio ever be a good sign?
Yes, if the company can service its debt comfortably, a higher ratio can boost returns through leverage and fund expansion, especially when borrowing costs are low.
How often should investors check a company’s debt to equity ratio?
It’s wise to review it every quarter or during financial reporting periods to track changes in the company’s financial structure and risk exposure.
Does debt to equity ratio include short-term debt?
Yes, the standard calculation includes both short-term and long-term liabilities, though some investors focus only on long-term debt for a clearer view of financial risk.
