The debt-equity ratio trivia

By BankBazaar | April 4, 2011

What does it mean?

It is calculated by dividing the company’s total liabilities by the total equity fund belonging to the shareholders. It reflects the proportion of equity and debt that the company has employed to finance its assets. Usually only long–term debts are considered when computing this ratio.

If a company is having a high ratio, it simply means it is opting for a debt investment technique. Usually this type of financing approach is opted by capital intensive industry as they need a huge proportion of investment to expand. It is not a matter of concern if such debt helps increase the earnings of the company since, the debt cost gets adequately covered and the shareholders have a share of this increased earning as well.

A low ratio would mean that the company is dependent more on its cash reserves and money raised through equity route. This pursuit is followed by those companies whose capital requirement is low. But, in some cases it may also mean that it is a defensive company and hence future growth prospects may not be strong.

What it means for you

A company having a high debt-equity ratio should be a matter of concern, if it remains for a high for a significant period of time or has been increasing steadily. So, if you do not want to be loosing your hard earned savings and enter into a debt by opting a personal loan, home loan etc. Avoid making unwise decisions. Consider studying all options of investing in a company.

You definitely need to understand the fundamentals of that particular company before investing. A high ratio would mean that the company has opted for a rigorous debt route to finance its assets; a route which is bound to wipe out the gains due to mounted debts over a long period of time. But, remember that the debt-equity ratio, is not the only criteria for picking a stock. There are many other parameters, such as return on equity, management and earnings per share, that should be analyzed before you make your investment decision.

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