The debt-to-equity ratio is a financial ratio that measures the amount of a company’s debt relative to its equity. It is calculated by dividing the company’s total debt by its total equity.
A Story to understand meaning of Debt Equity Ratio
Once upon a time, there was a young girl named Alice who loved to bake cookies. She decided to start her own cookie business, and she needed to buy some ingredients and equipment to get started.
Alice had some money saved up from her allowance and birthday gifts, but it wasn’t enough to buy everything she needed. She decided to borrow some money from her parents to help finance her business.
As Alice’s cookie business grew, she started to make more money from selling cookies. She used some of this money to pay back the loan from her parents and also to save for the future.
Alice’s business continued to grow, and she started to get orders from stores and online customers. She needed to borrow more money to buy more ingredients and equipment to meet the demand for her cookies.
As Alice’s business grew, she started to think about how she could measure its financial health. She heard about something called the debt-to-equity ratio, which was a way to measure how much of her business was financed by debt (like the money she borrowed from her parents) versus how much was financed by equity (like the money she saved up).
Alice calculated her debt-to-equity ratio and found that it was relatively low, which meant that she wasn’t relying too heavily on borrowing money to finance her business. She was happy to see that her business was financially stable and had a good balance between debt and equity.
Alice continued to grow her cookie business and was always careful to keep an eye on her debt-to-equity ratio to make sure that it remained healthy. And she lived happily ever after, baking cookies and making delicious treats for people all over the world.
Formula
Debt / Equity, where
Debt – It covers all long term or non-current liabilities of the company
Equity – It covers shareholders’ funds i.e. share capital + Reserves and Surplus
How to Calculate
Debt covers all the non-current liabilities of the business. Its sub heads are as follows :
| S No | Sub Head | Items | Brief Explanation |
| 1 | Long term borrowings | Debentures | |
| Bonds | |||
| Term Loans from a) Banks b) Other Parties | |||
| 3 | Public Deposits | ||
| Other Loans and Advances | |||
| 2 | Deferred Tax Liabilities (Net) | Income Tax on (Accounting Income – Taxable Income) | |
| 3 | Other Long term Liabilities | Any long-term liability other than long term borrowings | |
| Trade Payables | Sundry Creditors and Bills Payable | ||
| Others | Premium on redemption of debentures if debentures are long term | ||
| Premium on redemption of preference shares if preferences shares are long term | |||
| Advances from Customers – Long term | |||
| 4 | Long Term Provisions | Provision for Employee Benefits | Provision for Gratuity, Leave Encashment, Provident Fund, etc. |
| Others | Provision for warranty claims | ||
Equity Means the Shareholders funds.Its sub heads are as follows :
| S No | Sub Head | Items | Brief Explanation |
| 1 | Share Capital | (Equity + Preference) and (Cash + Non Cash) | Discussed in details in Company Accounts Chapter |
| Reserves and Surplus | Amount set aside out of profits. For each item show Opening Balance, Additions/Deductions and Closing Balance+G8 | ||
| Capital Reserve | Reserve created out of Capital Profits | ||
| Capital Redemption Reserve | Reserve created when company purchases its own shares out of free reserves | ||
| Securities Premium Reserves | Excess of Issues price over Face Value | ||
| Debenture Redemption Reserve | Reserve created for the purpose of redemption of debentures | ||
| Revaluation Reserve | Reserve created due to upward revision of assets value | ||
| Share Options Outstanding Amount | Difference between Market Value and Issue price of shares issued to employees | ||
| Other Reserves | |||
- Workmen Compensation Reserve | |||
- Investment Fluctuation Reserve | |||
- Subsidy Reserve | |||
- General Reserve | |||
| Surplus | Balance in Statement of Profit & Loss A/c i.e. Accumulated profits not appropriated or distributed as dividends |
Interpretation
The debt-to-equity ratio is used to evaluate a company’s financial leverage, or the extent to which the company is using debt to finance its operations and growth. A high debt-to-equity ratio may indicate that a company has high levels of debt relative to its equity, which could be a sign of financial risk. On the other hand, a low debt-to-equity ratio may indicate that a company has low levels of debt relative to its equity, which could be a sign of financial stability.
A low debt equity ratio is always good for business. The higher the debt equity ratio it shows that the company is more leveraged and runs a higher risk when the business cycle turns adverse.
The lenders will be reluctant to give loans at favorable terms to a company which has a high debt equity ratio