Debt to Equity Ratio – Meaning, Assumptions and Interpretation

The debt to equity ratio is the most important of all capital adequacy ratios. It is seen by investors and analysts worldwide as the true measure of riskiness of the firm. This ratio is often quoted in the financials of the company as well as in discussions pertaining to the financial health of the company in TV shows newspapers etc.

Formula

Debt to Equity Ratio = Total Debt / Total Equity

The total equity includes retained earnings which have been listed on the balance sheet

There is subjectivity with regards to treatment of preference shares. Some companies add them to debt while others add them to equity based on the relative features of the preference shares issued. However, usually the quantum of preference shares in not big enough to make a difference.

Meaning

The debt to equity ratio tells the shareholders as well as debt holders the relative amounts they are contributing to the capital. It needs to be understood that it is a part to part comparison and not a part to whole comparison.

Assumptions

The debt to equity ratio measures the amount of debt based on the figures stated in the balance sheet. Of late there have been many ways figured out to take on debt without it showing up on the balance sheet.

The debt to equity ratio is a very old measure and is not meant to take into account such complication. Some analysts factor in off balance sheet debt as well to get a better picture. However, they do not have enough information to be very accurate at this endeavor.

Interpretation

Debt to equity ratio provides two very important pieces of information to the analysts. They have been listed below.

• Interest Expenses: A high debt to equity ratio implies a high interest expense. Along with the interest expense the company also has to redeem some of the debt it issued in the past which is due for maturity. This means a huge expense. Moreover this expense needs to be paid in cash, which has the potential to hurt the cash flow of the firm. Investors are never keen on investing in cash strapped firm and therefore have a keen eye on this ratio.

• Liquidation Scenario: Another interpretation of the debt equity ratio is the event of a liquidation of the company.

  Shareholders as well as debt holders want to know what the maximum downside is and debt to equity ratio helps them understand what they would end up with if the company were to stop functioning as a going concern.