What is debt-equity ratio & its importance

One of the important terms in the financial books is debt. It includes the firm liability portion which is compiled to pay back in one year or two. Debt plays an important role during fiscal.

Debt includes long-term Loan generally more than one year, from Bank or Financial institutes to run the business. If we look closely Debt is also important for the company to run their business.

Some of the company is also debt free. Debt-equity ratio reveals the company performance against their debt.

Also Read: What is Book Value (BV)?

Rise in debt is the serious concern for the investor as well as the owner, some time rise in debt also indicates that the management if pouring cash into their business.

Debt-equity ratio is closely monitored by the investor, whether the decision of investing the money in their company is going in the right direction.

Debt-equity ratio calculator

The Debt-equity ratio is calculated by dividing the total debt by company equity. Debt includes all type of debt long term as well as short-term.

Equity means the sum of money received by the company at the time of sale of sales, and also the company earning (the profit not paid to the shareholders as a dividend).

D/E = Total Liability / (Total Assets – Total Liability

Also Read: Debt to Assets Ratio – (Calculation and Importance)

Importance of Debt-equity ratio

For most companies, the maximum acceptable debt-to-equity ratio is 1.5-2 and less. For large public companies the debt-to-equity ratio may be much more than 2, but for most small and medium companies it is not acceptable.

High debt ratio clearly indicated that the company unable to generate enough cash to satisfied the debt.

Every company works on their own business model within the same industry, If you keep an eye on the reduction of debt with the same circumstances to the company with same industry, that means the company is working better then the other company in the sector.

Also Read: What is Dividend Adjusted PEG Ratio

High D/E Ratio not only bad for every sector but in the manufacturing sector, it may not be so bad.

Limitation of Debt to Equity Ratio

It is very important before calculating the debt-equity ratio of the company, to consider the industry in which the company operates.

Because different company relies on different capital required. Some industry indicates high D/E ratio and some indicated low D/E ratio.

Also Read: What is Operating Profit Margin Ratio?

Basically, this ratio works for the same sector not for the different industry.

Another limitation for the investor is some companies total liability portion is considered by loans and debt securities and some companies consider the long-term as well as short-term loan too, this debt to equity ratio phenomena changes the whole story of the company.

You must go for other performance meters to get the clear picture.

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