What Is the Debt to Equity Ratio Formula and How Does It Work?

If you are familiar with stock markets, you must know that there are 2 ways to analyze a stock. Yes. You guessed it right. Fundamental and Technical Analysis. One of the most widely used fundamental analysis tools is the debt-to-equity ratio formula.

This ratio is a must for analyzing a company’s financial health. By studying the debt-to-equity ratio of a company, you can evaluate its growth potential and financial stability.

In this blog, we will discuss the debt-to-equity ratio formula and its uses. We will also cover how to calculate debt-to-equity ratio, its variations, and its application in different scenarios.

What Is the Debt to Equity Ratio Formula?

To put it simply, the debt-to-equity ratio formula is a measurement of the relation between a company’s Total Debt and Shareholder’s Equity. It shows the portion of the company’s assets that are financed by external debt compared to shareholder’s equity.

Debt to Equity Ratio Formula:

Debt to Equity Ratio=Total DebtShareholder’s Equity

It is one of the foremost ratios to understand the financial leverage of a company and whether it can sustain itself in the long run or not.

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Different Variations of the Debt to Equity Ratio Formula

Although the standard formula for the debt-equity ratio is widely used, it has some variations depending on the following parameters:

• What is the context and purpose of the analysis?
• Which industry are you trying to analyze?
• Type of business run by the company.

Long-Term Debt to Equity Ratio Formula

As the name suggests, the long-term debt-to-equity ratio formula is used to understand the long-term financial stability of a company’s finances. Hence, it excludes the short-term liabilities. Here’s the formula:

Long-Term Debt to Equity Ratio=Long-Term DebtShareholder’s Equity

Total Debt to Equity Ratio Formula

The total debt to equity ratio formula considers all types of liabilities of a business, whether short-term or long-term. It shows the entire financial health of a business, whether it has the assets to cover its external debts or not. Here’s the formula:

Total Debt to Equity Ratio=Total DebtShareholder’s Equity

Debt Equity Ratio Formula for Proprietorship

There are no shareholders in a proprietorship, and the capital contributed by the proprietor is the only source of funds for the business. Hence, the debt-equity ratio formula for proprietorship makes this change. Here’s the formula:

Debt to Equity Ratio (Proprietorship)=Total DebtOwner’s Capital

Debt Equity Ratio Formula for Banks

For a bank, the short-term and long-term deposits accepted from people also become a liability. Hence, they are added in the debt-equity ratio formula for banks. Here is the formula:

Debt to Equity Ratio for Banks=Total Debt + DepositsShareholder’s Equity

How to Calculate Debt to Equity Ratio?

You can follow these steps to calculate the debt-to-equity ratio:

Step 1: Identify the Total Debt

Combine all the short-term and long-term liabilities like:

• External Loans
• Bonds
• Other Financial Obligations

Step 2: Determine Shareholder’s Equity

You can obtain these details from the balance sheet of a company. Usually, these 3 things are added:

• Paid up Capital
• Retained Earnings
• Reserves and Surplus

Step 3: Apply the formula

When you have all the necessary figures in your hands, you can apply the debt-to-equity ratio formula.

Debt to Equity Ratio=Total DebtShareholder’s Equity

Debt to Equity Ratio Formula Example

Let’s try to understand the application of the debt-to-equity ratio formula with the help of an example. Here’s an excerpt from Company A’s balance sheet.

Particulars	Amount (Rs.)
Long-term Debt	30,00,000
Short-term Liabilities	20,00,000
Shareholder’s Equity	20,00,000

Now, let’s calculate the Total and long-term debt-to-equity ratios.

Total Debt to Equity Ratio=Total DebtShareholder’s Equity=30,00,000 + 20,00,00020,00,000=2.5

Long-Term Debt to Equity Ratio=Long-Term DebtShareholder’s Equity=30,00,00020,00,000=1.5

Although we will learn about the interpretation of the ratio in the coming sections, Company A has a high debt-to-equity ratio and is highly leveraged. It can be difficult to sustain in a bad economy.

When to Use the Debt-to-Equity Ratio?

Due to its versatility, the debt-to-equity ratio can be used in different situations. Here are some examples of major scenarios in which it is useful:

• Investment Decisions: Investors who want to invest in a company want to understand its financial structure and the risk involved in investing.
• Loan Approvals: The banks use the debt-to-equity ratio to determine the creditworthiness of a business. If a company is financially healthy, its loan gets approved.
• Industry Comparison: Businesses use it to compare their health with the industry average. Maintaining your ratios close to the benchmark is good for your business.

Interpreting the Debt-to-Equity Ratio

Now that you know how to calculate the debt-to-equity ratio, let’s take a look at how the results can be interpreted:

• Less than 1: There are 2 ways to interpret it. One is that the company relies less on debt and is financially stable. But another way to look at it is underutilization of leverage.
• 1 to 2: This is the ideal state for all industries. It shows that the debt and equity are utilized in a balanced way.
• More than 2: It shows a high reliance on debt. Although the short-term profitability is boosted, the business operates at a high risk.

However, the ratios need to be interpreted differently for each industry. For example, the banking industry always has a higher debt-to-equity ratio because of deposits. Similarly, manufacturing companies prefer a lower ratio to reduce risk.

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Limitations and Considerations

You have understood the importance and usage of the debt-to-equity ratio formula. But are there some limitations to this formula? Let’s find out:

• Doesn’t count intangibles: As intangibles like brand value cannot be quantified, they are excluded from the debt-equity ratio.
• No benchmark: There is no universal benchmark for the debt-to-equity ratio, and the standard can vary from industry to industry.
• Static Picture: It gives only a static picture of the business at a single point. But, the variables keep changing regularly.

Conclusion

The debt-to-equity ratio formula is a key metric to assess the financial viability of a company. Whether you are an investor, a lender, or any other interested party, it is helpful to make informed decisions. You can also use variations like the long-term debt-to-equity ratio formula to ascertain specific aspects of the business.

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