Debt Equity Ratio

This ratio is calculated to know the long term financial position of the company. It shows the relation between the long term debts and shareholders fund or net equity of the company. It tells us that how much portion of the funds is acquired from long term borrowings. It is calculated as follows:

Debt Equity Ratio= Debt / Equity

OR

Debt Equity Ratio=Long Term Debts/Shareholder’s Funds

Here two terms are important – Debts or we can say Long term debts and Equity or we can say Shareholder’s Fund. Let’s know it.

Debt: It means Loans or Borrowings of the company. But we include only long term loans and provisions in this which mature after one year. Examples:

• Debentures
• Public Deposits
• Bank Loans (more than one year duration)
• Mortgage Loan
• Loan from Financial Institutions
• Long term Provisions

Equity: It means Shareholder’s fund or we can say Net Worth of the company. It includes share capital and Reserves & Surplus. Examples:

• Equity Share Capital (if any)
• Preference Share Capital (if any)
• Capital Reserve
• General Reserve
• Profit and Loss account Balance
• Premium on Securities

Ideal Ratio : 2:1

Example: Calculate Debt Equity Ratio from the following particulars:-

Equity Share Capital             ₹2,00,000

Preference Share Capital      ₹1,00,000

P & L Balance                     ₹50,000

Loan from Bank                  ₹3,00,000

General Reserve                  ₹1,20,000

11% Debentures                 ₹6,00,000

Current Liabilities                 ₹20,000

Securities Premium              ₹50,000

Solution:

Debt Equity Ratio = Debt / Equity

Debt = 11% Debentures + Loan from Bank

        = ₹6,00,000 + ₹3,00,000

        = ₹9,00,000

Equity = Equity Share Capital + Preference Share Capital +

             + P & L Balance + General Reserve + Securities

             Premium

          = ₹2,00,000 + ₹1,00,000 + ₹50,000 + ₹1,20,000 +

              ₹50,000

          = ₹5,20,000

Debt Equity Ratio = ₹9,00,000 / ₹5,20,000

                        = 1.73:1

Significance of the Ratio: This ratio shows the extent of funds provided by long term lenders in comparison to the funds provided by the owners. Generally, debt equity ratio of 2:1 is considered safe. If this ratio is higher than it, then it will indicate a risky financial position for long term lenders. If this ratio is lower than 2:1, then it is better for long term lenders because they are secure.