To ascertain the financial health of a company, amongst other things, it is important to analyze the capital structure of the company to understand how much of borrowed money does the company operate with. One of the most important financial indicator and which gets every investors attention is the debt to equity ratio.
The capital structure of a company is made of of – equity and debt capital. When a business takes a loan to finance its business plans and projects (i.e. product development, capacity expansion etc), it becomes obligated to not only pay back the amount of borrowings but also the constant interest charges on the borrowed sum. As long as the borrowed money is well invested and generates sizable returns, the burden is not difficult to carry, but when the profit margins dry out, in bad economic times or for any other business related reason, it becomes difficult for the business to continue operating as efficiently, as the interest costs start eating into the profits.
What is an Ideal Capital Structure?
The debt-equity ratio is a statistical measurement of the amount of borrowing which the company takes vis-a-vis the amount of shareholder funds in the company. Similarly, long term debt to equity ratio is long term borrowings of a company (i.e. with maturities exceeding 1 year), divided by the total amount of money brought in by the shareholders.
Debt to Equity Ratio = (Total Debt / Total Equity)
ABC Limited has borrowings of Rs. 5,000,000 and shareholder equity of Rs. 8,000,000.
Debt to Equity ratio = 5,000,000 / 8,000,000, or 0.63
A low ratio figure would indicate that the firm is financially sound, with assets that can keep it buoyant in economic slowdowns. On the other hand a very high ratio value would mean that the company has borrowed heavily and is in a risky financial position. Companies with high levels of debt find it increasingly difficult to service the interest on their borrowings as profit margins decline and when the business is not generating enough. At such times, the interest charges start eating into the company’s profit often resulting in a net loss.
- In an ideal capital structure, this ratio should not be higher than 0.6-0.8. Of course it would also depend upon the sector / industry in which the business operates (see the link below).
- Debt is not always bad – if a business ‘makes profits higher than the interest charges on borrowed money’ it will create value for shareholders as more earnings will become available for distribution amongst them after payment of interest charges.
For more on these points, also see – Return on Capital Employed.
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