Debt Equity Ratio

A corporation finances itself in two ways.

The first is debt.

This could take the form of bank loans or a bond issue.

The second is equity.

This occurs when the company issues equity, that is later traded on the stock market.

The debt equity ratio tells us how much debt a firm uses relative to its equity.

For example, suppose a firm has equal amounts of debt and equity. Then the debt equity ratio, or the total debt divided by total equity, is equal to one.

If the debt equity ratio is larger than one, the firm has more debt than equity, and vice versa.

Typically, debt equity ratios vary by industry. Some industries, such as banks, tend to have relatively more debt, and higher debt equity ratios.

Other industries, such as technology firms, tend to have less debt, and lower debt equity ratios. For this reason, it's best to compare debt equity ratios across firms in similar industries.

Companies with high debt equity ratios are riskier. This is because interest payments on debt must be made at regular intervals.

If the firm is unable to generate enough cash to service its debt, it's at risk of bankruptcy. Companies with low debt equity ratios can more easily survive periods of poor performance.

Companies with high debt equity ratios also earn a high return on equity. This is because the value of equity is relatively small.

Whenever you see a company with a high return on equity, it's important to check whether this is driven by high profit margins, or simply a higher debt equity ratio.

The Debt Equity Ratio Formula

The Debt Equity ratio is the total value of debt, or total liabilities, divided by the total value of equity.

These values are found on the balance sheet.

This ratio highlights how a company's capital structure is tilted either toward debt or equity financing.

An alternative calculation uses only long term debt instead of total debt. This is the long term debt to equity ratio.

Debt Equity Ratio = (total liabilities / total equity)

Note that since no market variables (i.e. share price) are used, the debt equity ratio does not tell us whether a stock is cheap or expensive.

Calculating the Debt Equity Ratio

Suppose Baja Auto's most recent total liabilities is Rs 3,781 crore.

And their total equity is Rs 17,034 crore.

Using our formula gives us a Debt Equity ratio of 0.22.

Bajaj Auto Debt Equity Ratio = Rs 3,781 crore / Rs 17,034 crore = 0.22

Comparing Debt Equity Ratio with Other Indicators

How does the Debt Equity ratio compare to other indicators, such as return on equity (ROE) or return on invested assets (ROA)?

The debt equity ratio is closely linked to both these indicators. In fact, there is a formula that links them all together.

ROE = ROA * (1 + Debt Equity Ratio)

The ROA is net income divided by total assets. The ROE is net income divided by total equity.

Both ratios measure a firm's profitability. If you are buying a stock, you are an equity holder. So the ROE is what matters to you most.

This formula helps us understand where a firm's ROE comes from.

It may be the case that a firm has a high ROE simply because it has a high debt equity ratio. If this is the case, the firm may be a high risk investment, and possibly should be avoided.

On the other hand, if a firm has a high ROE because its ROA is high, it implies the firm is highly profitable.

In other words, it's not using excessive debt to bump up its ROE.

Advantages and Limitations of High Debt Equity Ratio

A high debt equity ratio can be good because it shows that a company can service its debt obligations and is using the leverage to increase equity returns.

It can also be beneficial if the cost of debt is lower than the cost of equity. Thus increasing the debt equity ratio can lower a firm's weighted average cost of capital (WACC).

On the other hand, if the debt equity ratio gets too high, the cost of borrowing will zoom. The company's WACC will get extremely high. This will drive down its share price.

Investors require financial analysis to back up the risks they take in the stock market. Ratios like the debt equity ratio provide a picture of the company's capital structure.

Recommended Reading on Debt Equity Ratio

Here are Links to Some Very Insightful Equitymaster Articles and Videos on Debt Equity Ratio

• The Safest and Best Way to Get Rich in Stocks
• Of price and value and the great divide
• Investing: Back to Basics Article Series
• The Most Powerful Screener for Best Stocks of 2020
• Of These 2 Types of Stocks, Which One Would You Pick?
• Are Cheapest Stocks also the Best Performing Stocks?
• The World's Richest Man Believes in this Ratio. Are You Using It?
• How to Evaluate a Stock in India

Happy Investing!

FAQs on Debt Equity Ratio

1. What is debt-to-equity (D/E) ratio Formula?

The debt-to-equity (D/E) ratio is the total value of debt, or total liabilities, divided by the total value of equity.

Debt to Equity Ratio = (total liabilities / total equity)

2. Why is debt-to-equity (D/E) ratio important?

The debt-to-equity (D/E) ratio is an important financial metric as it highlights how a company's capital structure is tilted, either toward debt or equity financing.

While screening stocks, this is an important and obvious metric which investors look at because too much debt can sink a company.

3. How to use debt-to-equity (D/E) ratio to identify Multibagger stocks?

A multibagger stock has many qualitative characteristics and low debt-to-equity (D/E) ratio is one of them. An important one.

The idea here is to look for businesses consistently reducing their external loans and borrowings.

4. What is a good debt-to-equity (D/E) ratio?

A high debt to equity ratio is risky. Ideally, a ratio less than 1 is considered good, while anything above 2 is highly risky.

We highly recommend you check out Equitymaster's Stock Screener and its segments. Here are some of the screens related to debt.

Debt Free Companies

High Debt Companies

Top Companies with Debt Reduction