What is Debt to Equity Ratio? How to Derive It?
Gauging the performance of a company isn’t much difficult if you know certain ways and formulae used by most traders. A similar formula, debt to equity ratio, is a way to ascertain company’s value by determining its debt and assets. Hence, let us understand what does this ratio mean, how it works, and when should one use it.
Debt To Equity Ratio – Meaning
One can measure the current financial performance of a given company by calculating its debt to equity ratio. This is done by dividing the amount of liability the company has by the amount of equities it holds. The final amount derived will mention the debt to equity used by that firm to finance its assets.
Debt to Equity Ratio Formula:
Debt to equity of Company ‘X’ = Total Liabilities / Total Shareholders’ Equity
Liability, in this ratio, is not always the total amount of outstanding amount. Sometimes the amounts of long tern debt or even only interest bearing debts are mentioned instead of liability. Debt to equity ratio, however, is not only used to measure the financial performance of a company. It can also be used to find out a personal financial status.
This ratio can be made too intricate if one wants to gauge the actual value of a company. However, let’s keep it simple as of now. Simply divide the liabilities of a comaby by its assets.
How to Analyze Debt to Equity Ratio?
When the total amount of liabilities of a company exceeds the total amount of equities or assets, debt to equity ratio is higher, which definitely is not a positive sign. For an investor, this company must be avoided. Sometimes, when a company accumulates too much liability, chances are the company might find it difficult to repay resulting into insolvency. Hence, if you are investing in a high ratio company, you risk is too high.
This ratio would be 1 if total number of assets is equal to the total liabilities owned by the company. These kinds of companies are safe to invest in, as liabilities are low, which can be repaid by selling assets. So, chances of insolvency are minimal. One must, however, keep checking the ratio. If it’s rising, it’s probably time to get out of it.
When the ratio is lower than 1, total number of assets exceeds total number of liabilities, which is certainly a good sign for investors. With more assets in hand, this company would definitely invest in other areas and expand.
This ratio, however, is not the only way to gauge the performance of a company, and one must not rely only on this number. It may be different for different industries. An average debt to equity ratio of manufacturing sector, for instance, might by above 2, while that of IT companies might be 0.5.
