What is Debt Equity Ratio
What is Debt Equity Ratio?
In order to understand the actual meaning of debt-equity ratio, it is important to understand what is the meaning of these terms i. e. assets, liabilities, ratio, debt, equity. The precise meaning of these terms are as under:
Assets
All the things and resources on which the company has absolute ownership and have economic value particularly in terms of money. It includes both tangible assets like plant, machinery, store and stock, building and alike things and intangible assets like goodwill, patents, copyright etc.
Liability
In simple terms, liability is what the company has to pay to others or owes legally or by the business practice. The liabilities generally arise during the course of business.
These are discharged by monetary payments or sometimes in kinds like transfer of goods or services. some examples of liabilities are loans, bills payables, accrued expenses, public deposits etc. The liabilities are shown on the right side of the balance sheet.
Equity
Equity in general terms and in the very start of a business is the investment made by the owner(s) of the company to run a business and earn a profit. This is called the owner's equity.
By and by or for the expansion of business more and more capital is required which cannot be meet out by the owners and therefore the money is raised by allotment of shares.
The number of shares purchased by an individual or a company or financial institutes or general public, they get the ownership right to that extent in the company and also entitled for profit and loss of the company in the ratio of their shares owned.
This is called shareholders equity. The combination of both (owners + shareholders) equity is the total equity of the company.
The balance sheet of the business consists of two sides, assets and liabilities. Assets include what the company owns whereas liabilities show what the company owed. The liabilities include the amount or things payable to others.
Ratio
It refers to the relationship of two amounts or groups which can be quantified. This is for calculating relationship between the two given amounts or groups to see which one is greater or bigger than other.
Debt to Equity Ratio
The debt to equity ratio is the most important part of the financial statements of a business. It tells about the total debts of the company against total equity which means the equity of owners plus equity of shareholders against the debt i.e. what the company owes or has to pay.
This ratio also clarifies how much finance is raised by the company by way of debt (loans, advances, deposits) and how much by equity (owners investment). The basic formula to calculate the debt-equity ratio is:
Debt to equity ratio = Total Liabilities
----------------------
Total Equity
For Example:
In case the company A liabilities as on 31st March 2019 is $ 6,000 and the shareholder's equity was $ 5,000 than the debt-equity ratio will be:
Example 1:
Debt to equity ratio = $ 6,000
--------------- $ 5,000
Debt equity ratio = 1.2 : 1
Example 2:
Total liabilities $ 6,000
-----------------
$ 3000
Debt to equity ratio = 2 : 1
What is the good debt-equity ratio depends from industry to industry? More and more debt in comparison to equity is never desirable as the debt includes the part of the interest which will increase the cost of production or expenses of the company and thereby reduces the profit.
In fact, companies have low debt in comparison to equity not only earns more profit but also have more goodwill in the market which is very useful for the long survival of any organization.
In the case of companies having a big margin of profit, they may increase their debt to more than equity but it is always advisable that this ratio should not increase two third debt to one-third equity.
The more debt indicates overtrading whereas more equity shows undertrading. therefore, there must be the right decision in the selection of debt to equity ratio in consultation with finance experts.
CONCLUSION
Debt to equity ratio is very important process of financial accounting. It is very useful for the management to take decision about how much debt to be taken against equity in order to ensure that the business of the company earn maximum profit and the debts are paid well in time. The management also ensures that proper cash flows are maintained.
The more debt may fall the company into risk and will not be favoured by the creditors of the company. The banks, financial institutions and investors analysis the debt to equity ratio and cash flow statement at the time of calculating loans. So the management should always keep an eye on variation of debt - equity ratio throughout the period of their business.