DEBT-EQUITY RATIO - Accounts and Finance for Managers

It is the ratio expresses the relationship between the ownership funds and the outsiders’ funds. It is more specifically highlighted that an expression of relationship in between the debt and Shareholders’ funds. The debt–equity ratio can be obviously understood into two different forms

  • Long term debt–equity ratio
  • Total debt–equity ratio

Long-term Debt-equity Ratio

It is a ratio expresses the relationship in between the outsiders’ contribution through debt financial resource and Share holders’ contribution through equity share capital, preference share capital and past accumulated profits. It reveals the cover or cushion enjoyed by the firm due to the owners’ contribution over the outsiders’ contribution.

Debt - Equity Ratio=
Debt (Long term debt = Debentures/Term Loans)
Net worth/Equity (Shareholders' fund)

Higher ratio indicates the riskier financial status of the firm which means that the firm has been financed by the greater outsiders’ fund rather than that of the owners’ fund contribution and vice versa.

Standard Norm of the Debt-equity Ratio

The ideal norm is that 1:2 which means that every one rupee of debt finance is covered by the 2 rupees of shareholders’ fund

The firm should have a minimum of 50% margin of safety in meeting the long term financial commitments. If the ratio exceeds the specification, the interest of the firm will be ruined by the outsiders’ during the moment at when they are unable to make the payment of interest in time as per the terms of agreement reached earlier. During the moment of liquidation, the greater ratio may facilitate the creditors to recover the amount due lesser holding held by the owners.

Total Debt-equity Ratio

The ultimate purpose of the ratio is to express the relationship total volume of debt irrespective of nature and shareholders’ funds. If the owners’ contribution is lesser in volume in general irrespective of its nature leads to worse situation in recovering the amount of outsiders’ contribution during the moment of liquidation.

Total Debt – Equity Ratio=
Short term debt + Long term debt
Equity (Shareholders' fund)

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