Which lines on the balance sheet are the debt?
It sounds trivial, and it is not: two reputable sites will give the same company different answers depending on which lines they picked up.
On an Indian balance sheet both halves of the debt to equity ratio are named heads, prescribed by law. That makes the ratio something you can compute exactly rather than approximate.
What is the Debt to Equity Ratio Meaning?
The debt to equity ratio meaning is simple enough to state: it compares money the company has borrowed with money its owners have put in and left in.
A company can fund itself two ways. It can borrow, and owe interest and repayment, or it can use shareholders' money, which carries no promise to repay.
The ratio tells you how the funding splits between those two.
Debt to Equity Ratio Formula
Debt divided by equity, and the care is all in what each word points at.
Schedule III to the Companies Act, 2013 sets out the heads of an Indian balance sheet. Borrowings appears twice, once under non-current liabilities and once under current liabilities. Those two together are the debt.
Equity is a named head too, and its name depends on which division of Schedule III the company follows.
Accounts under
Division I show Shareholders' funds, which is share capital plus reserves and surplus. Listed companies follow Division II, where the same money appears as
Equity Share capital plus Other Equity.
Either way, you read equity off the statement rather than working it out.
Note what is left out. Trade payables, provisions and deferred tax are liabilities, and none of them is borrowed money.
How to Calculate Debt to Equity Ratio?
Take a company with long-term borrowings of ₹300 crore and short-term borrowings of ₹100 crore. Its share capital is ₹100 crore and its reserves and surplus ₹400 crore.
Debt is ₹400 crore and equity is ₹500 crore, so the ratio is 0.8.
Now suppose it also owes ₹200 crore to suppliers. Using total liabilities instead of borrowings gives ₹600 crore over ₹500 crore, a ratio of 1.2.
Same company, same day, two answers. The second one is measuring how slowly it pays suppliers, not how much it has borrowed.
Also Read: If you want to understand how a company’s size is measured in the stock market, read What Is Market Capitalisation.
What Does the Debt to Equity Ratio Mean?
A ratio of 1 means borrowed money and owners' money are equal.
Above 1, lenders have put in more than owners. Interest has to be paid whether or not the year goes well, so a higher figure means less room when it does not.
Below 1, the company leans on its own funds. That is safer and it is not free, because shareholders expect a return on their money too.
What is a Good Debt to Equity Ratio?
There is no good number, and anyone who gives you one has skipped the question that matters.
What a company can carry depends on how predictable its cash is. A utility with regulated revenues and a software firm without that certainty can hold the same ratio and be in very different positions.
Compare a company with its own past, and with others doing the same thing. A number on its own tells you the split, not whether the split is sensible.
Why is Debt to Equity Ratio Important for
Investors?
It answers a question the income statement cannot. Profit shows what a year produced, and this shows what stands behind it.
Two companies can report the same profit while one owes nothing and the other is servicing borrowings out of it. Earnings Per Share (EPS) will not separate them, and this will.
It also flags where the risk sits. Interest is a fixed claim, and fixed claims are what turn a bad year into a serious one.
Limitations of Debt to Equity Ratio
The definition is not settled in practice. Borrowings over equity and total liabilities over equity are both in circulation, and they answer different questions.
It is also sector-bound. Capital-intensive businesses borrow because assets cost money, so comparing them with asset-light ones tells you about the industries rather than the companies.
The ratio also assumes a company that borrows to fund assets. A bank does not fit that.
Deposits are the largest thing on a bank's balance sheet, and taking them is the business rather than a way of financing it. The ordinary arithmetic does not describe the same thing, and a low figure computed that way is not reassuring.
Finally, it is a snapshot: a balance sheet is one date, and borrowings can be repaid the week after.
Conclusion
The ratio is one division, and its accuracy depends entirely on picking up the right lines.
Schedule III names both of them: borrowings, long-term and short-term, over total equity.
Leave trade payables and provisions out, because they are liabilities rather than borrowings, and including them answers a different question.
Then compare the result with the company's own history and its own sector. The figure describes how a business is funded. It does not tell you whether the business is a good one, and the PE
ratio does not answer that either.
