Debt-Equity Ratio

Debt-Equity Ratio is a type of Solvency Ratio that determines the relative contribution of creditors and the shareholders in the company’s funds. Creditors' contribution is termed as Debt whereas Shareholder’s contribution is termed as Equity. It is a measure to which a company depends upon outsiders for its operations.
Debt-Equity Ratio = Total Liabilities / Total Equity
Where,
  • Total Liabilities = Long Term Liabilities + Current or Short-Term Liabilities; hence, total liabilities include all debts/liability payable within a year and payable in the long-term.
  • And Total Equity = Total Assets - Total Liability; total assets and total liability include current as well as non-current assets and liabilities, respectively. It also includes Reserves and Surplus of the company.

Significance and Interpretation

    • Debt - Equity Ratio = 1: This implies that the total equity is just enough to pay all the debts, the company is not in a debt position wherein all equities are not enough to clear the debts
    • Debt – Equity Ratio < 1: This implies that the company is in a safe position, total equities are more than the total debt which turns to be favorable for the company in times when the interest rates rise.
    • Debt – Equity Ratio > 1: This implies that the total debts of a company exceed its total equity and the company is in debt-ridden position, the company faces lots of issues in times when the interest rates rise.
  • The ideal Debt-Equity Ratio <1, which indicates that the company has enough equities to fulfill the debts (both current as well as non-current). Debt – Equity Ratio is acceptable up to the value 1 wherein total liabilities equals the total equities. However, it must be noted that this limit may shift depending upon the regulatory reforms and/or type of business.
A low Debt-Equity Ratio is beneficial for lenders to the company, wherein a high Debt-Equity Ratio is beneficial to the company for trading in Equities.

Examples

Example 1: M/S ABC Ltd. reported short term debts worth ₹50 Crores, long term debts worth ₹150 Crores, and total equity as ₹300 Crores, find the debt-equity ratio of M/S ABC Ltd.
  • Solution: Total Liability = Short Term Liability + Long Term Liability = ₹200 Crores
  • Total Equity = ₹300 Crores
  • Debt-Equity Ratio = Total Liability / Total Equity = 200/300 = 2/3
  • Hence, Debt–Equity Ratio = 2/3 or 0.6667
Example 2: The following information is available about M/S XYZ Ltd, find the debt-equity ratio of the firm.
Sr. No Particulars Amount (in ₹ Cr)
1 Current Liability 500.00
2 Non-Current liability 100.00
3 Current Asset 150.00
4 Non- Current Asset 800.00
5 Reserves and Surplus 50.00
  • Solution:
  • Total Debt = Current Liability + Non-Current Liability = 500 +100 = ₹600 Crores
  • Total Equity = Total Assets – Total Liability = (Current Asset + Non-Current Asset + Reserves and Surplus) – (Current Liability + Non-Current Liability)
  • Hence, Total Equity = 1000 – 600 = 400 Crores
  • Debt–Equity Ratio = Total Debt / Total Equity = 600/400 = 3/2
  • Hence, Debt–Equity Ratio = 3/2 or 1.5
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