Understanding Debt Equity Ratio | Formulae | Significance

Debt Equity Ratio

It is otherwise called as External-Internal Equity Ratio. This ratio is calculated to know the level of claims of the outsiders and owners i.e. shareholders claim over the assets of the business concern.

Debt-equity ratio indicates the relationship between the external equities and internal-equities or the outsiders funds and the shareholders’ funds. The following formulae are used to calculate the debt equity ratio.

Debt Equity Ratio = External Equities / Internal Equities

or

Debt Equity Ratio = Outsiders’ Funds / Shareholders’ Funds

The term outsiders’ funds include all debt/liabilities to outsiders whether long term or short term.

Equity share capital, preference share capital, capital reserve, revenue reserve, accumulated profits and surpluses like reserves for contingencies, sinking fund etc. are included in the shareholders’ funds. The accumulated losses and deferred expenses, if any, should be deducted from the total to find out shareholders’ funds. Such amount is also called as net worth.

Net worth = Shareholders’ Funds — Accumulated Losses and Deferred Expenses

The redeemable preference shares and non-convertible preference shares are included in the outsiders’ funds compute this ratio.

Likewise, irredeemable preference shares and convertible preference shares are included in the shareholders’ funds. The reason is that both redeemable preference shareholders and non-convertible preference shareholders are getting their principal amount at the end of specific period just like debenture holders.

Likewise, irredeemable preference shareholders are getting the dividend throughout the life of the business concern just like equity shareholders.

The convertible preference shareholders, getting equity, have certificates at the end of specific period and treated at par with existing equity shareholders. If any other type of preference shares are issued by the business concern, an analyst uses his/her own discretion for the computation of this ratio.

If current liabilities are excluded from the outsiders’ funds, the net amount can be treated as long term debt. If so, one more ratio is calculated i.e. Long term debt to shareholders’ funds ratio. In this case, the following formula is used.

Long Term Debt to Shareholders’ Funds Ratio =  Long Term Debt / Shareholders’ Funds

Significance of Debt Equity Ratio

This ratio is calculated to know the extent of debt used in the business concern. The outsiders are calculating this ratio to know the liquidity position of the company. Generally, the owners of the business concern wants to use the funds of outsiders at the maximum. If so, owners assume lesser risk on their investments and can increase their earnings per share by paying a lower fixed rate of interest to outsiders.

In other words, trading on equity benefits are available to the owners i.e. shareholders. On the other hand, the outsiders want that the owners i.e. shareholders should invest more and reduce the risk of outsiders.

There is no standard to debt equity ratio. Low ratio refers to debt being low in comparison to shareholders’ funds. A high debt equity ratio indicates the high level of claims over the assets of the business concern and provide a large margin of safety to the outsiders while running of a business concern.

At the same time, a high debt equity ratio gives a lesser margin of safety at the time of liquidation of the business concern to the outsiders. Besides, the company is unable to get adequate credit facility and getting credit facility by paying very high rate of interest and without accepting undue pressures and conditions of the creditors.

Hence, it is advisable to maintain low debt equity ratio from the company point of view. The reason is that the company can get adequate loan facility from the outsiders with low rate of interest to magnify their earnings. But, in any way, the interpretation of this ratio is depending upon the purpose of analysis, the financial policy and nature of the business concern.

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