Debt-equity ratio analysis: Why the debt-equity ratio is important?

The debt-equity ratio of a business refers to the contribution of capital invested by creditors, shareholders and owners in the business. It is a financial tool, used to estimate how much amount can be borrowed using shareholder contributions. A debt-equity ratio can be defined as a capital structure ratio. It is used to evaluate the financial stability of a business for long periods using sheet data. The debt-equity ratio is viewed differently by different classes such as lenders, investors, management and government when assessing the company’s position. Interpretations of financial ratios may vary according to different people.

For example, investors and creditors use this data to make effective investment decisions. If the company has sufficient capital to meet its short-term and long-term obligations, the business is considered a solvent (solvent). Thus this data is used by creditors and investors to understand the long-term solvency of a company or business. The debt-equity ratio matters a lot. Therefore, information about this is being given through this article.

Why the debt-equity ratio is important?

A debt-equity ratio is a general equation that provides data about the collection of money and simply describes how the fund has been raised to run the business. It is considered an important indicator of the financial health of a business. It is mainly used to understand the company’s stability and ability to raise additional capital for growth and expansion.

If you own a company, this ratio will be used when you want to take advantage of debt or business line of credit. Investors see the debt-equity ratio of a company as an important financial indicator, as it helps them understand the risks involved in investing in a particular company. The higher the debt-equity ratio of a company, the riskier it is to invest in.

What debt-equity ratio is considered good?

When the debt-equity ratio is around 1 to 1.5, it is considered good. But the ratio is not constant for every industry. It depends on the industry and varies, as some industries use credit more than other industries finance it. Some industries such as financial and manufacturing, which often require more capital, typically have higher debt-equity ratios. In these it can be more than 2. When the debt-equity ratio of the company is high, it means that the company mainly uses debt for the growth and financing of its business. In addition, companies that invest more in assets and operations also have higher debt-equity ratios. It is often seen differently by investors and lenders. The high debt-equity ratio for the lender means that the business is running through debt and will not be able to repay its debts in the future. If a company has a low debt-equity ratio, it means that the company has enough money and does not believe in operating by borrowing. In contrast, investors are more likely to invest in enterprises that have a higher debt-equity ratio. Investors often avoid investing in enterprises with low debt-equity ratios, as such a company does not realize its full potential through public lenders.

Debt-equity ratio formula

We already know about debt-equity ratio, let’s now try to understand its formula –

Debt-equity ratio = total liabilities / shareholder’s equity

The formula consists of two elements, which are –

Total Liabilities – It shows the total loan taken by the company. These include short-term and long-term debt and other liabilities such as tax liabilities etc.

Shareholder’s equity The result obtained by subtracting the company’s assets from total liabilities reflects shareholder’s equity.

Profit when the debt-equity ratio is high

A high debt-equity ratio can sometimes be good, as it indicates that the business can easily meet its debt obligations through its cash flow and is using debt to increase returns.

Loss on high debt-equity ratio

In cases when the company’s debt-equity ratio is very high, the company’s liabilities are high and the company may lose the ability to repay its debts. In such cases the cost of borrowing in the form of WAAC of the company becomes very high and the cost of equity also becomes higher and thus the price of the company’s shares decreases.