Accountancy · Ch 9 — Accounting Ratios
Debt-Equity Ratio
Debt-Equity Ratio
The Debt-Equity Ratio measures the relationship between long-term debt and the equity (shareholders’ funds) of a business. It tells you what proportion of the total long-term capital employed comes from borrowed funds versus owners’ funds. A smaller debt component means outsiders (lenders) feel more secure because the company relies less on borrowed money. From a safety perspective, a capital structure with less debt and more equity is considered favourable — it reduces the chances of bankruptcy.
Normally, a debt-equity ratio of 2 : 1 is considered safe, but this benchmark can vary from industry to industry.
Formula
Debt-Equity Ratio = Long-term Debts / Shareholders’ Funds (Equity)
Long-term Debts include all non-current liabilities that carry an obligation to pay interest or principal after one year. In the balance sheet, these are:
- Long-term borrowings
- Other long-term liabilities
- Long-term provisions
Shareholders’ Funds (Equity) can be computed in two ways:
Method 1 (Direct from the equity side):
Shareholders’ Funds = Share Capital + Reserves and Surplus + Money received against share warrants + Share application money pending allotment
Share Capital = Equity Share Capital + Preference Share Capital
Method 2 (Using the asset side):
Shareholders’ Funds = Non-current Assets + Working Capital – Non-current Liabilities
Where Working Capital = Current Assets – Current Liabilities
Both methods give the same result. Method 2 is useful when the balance sheet is given in a vertical format and you want to cross-check.
Significance
This ratio measures the degree of indebtedness of an enterprise. For a long-term lender, it gives an idea of how secure their loan is. A low debt-equity ratio reflects more security — the company has a larger cushion of owners’ funds to absorb losses. A high ratio is considered risky because the firm may struggle to meet its obligations to outsiders (interest and principal repayments).
However, from the owners’ perspective, greater use of debt (called trading on equity) can help in ensuring higher returns for them — provided the rate of earnings on capital employed is higher than the rate of interest payable on the debt. This is the classic trade-off: debt magnifies returns when times are good, but increases risk when earnings fall.
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