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How to interpret Debt to equity ratio? How to calculate Debt to equity ratio?

How to read Debt to equity ratio?

is the significance, calculate Debt to equity ratio?

Debt can be good or bad based on the execution of the plan, if the execution is perfect then debt can be converted into cash reserves, if not then debt will keeps on increasing.

Debt to equity ratio is one of the ratio which keeps tracking the debt v/s equity of the company, whenever the company is not using its debt wisely it will get reflected on the balance sheet with the help of this ratio.

How to interpret Debt to equity ratio? How to calculate Debt to equity ratio?

What actually is debt to equity?

On such measure to know how much leverage a company is having is debt to equity ratio which tells you “how much debt company is having for 1 rupee of equity”. The debt used in the calculation is the total liabilities of the company, all non-current liabilities, current liabilities and other account payables also.

Debt to equity ratio falls under the category of leverage ratio, it is one of the many important tool in the market which investors and analysts used to calculate the leverage over the company and its peer.

This article will address till what value of debt to equity ratio you must consider yourself to be safe in company, but it doesn’t need any explanation for that, it is just a figure that any value higher than 2.0 is consider as risky in the market and on the other hand a debt to equity ratio of 1.0 is mostly of the blue-chip stocks.

How it is calculated?

Debt to equity ratio is given as:

The ratio of total liabilities to the total shareholder’s equity.

Debt to equity ratio (D/E) = Total Liabilities/ Shareholder’s equity

Total liabilities will going to calculated by calculating all non-current liabilities, current liabilities and account payables.

Total liabilities = Non-current liabilities + current liabilities + account payables

How to interpret the debt to equity ratio?

To interpret the figure comes out from the formula and consider the figure with the peer of the industry is what the use of D/E ratio is all about. But how to know which value of D/E ratio is good and which value can be bad.

It depends on the industry, it totally depends on the industry, the sector because for the sector which are capital intensive the value of D/E ratio comes out extremely massive as compared to other companies ratio.

  • But for to have a little bit bible rule you can consider the figure 1.0 as the very good figure, because it is generally found in the blue chip stocks and see what does it means?
  • It means that for 1 rupee of shareholder’s equity company is taking rupee of debt, and whenever any company in its earlier times gone through this phase it will become multi-bagger in future, because all the strategies and plans of the company get reflected on the balance sheet and P&L statements.
  • A ratio greater than 2.0 as discussed above can be predict as the high risk to high reward company, better to stay away from these type of company.

Is D/E<1 ratio good?

Debt to equity ratio shows that the company is using leverages for to attain missions of generating high cash reserves, and other business activities. But if the business is wisely using its cash reserves and not taking too much debt then it in turn going to shareholder’s interest in the company because ultimately the company is generating more outcomes on one side and with not so much debt over it.

But having a value close to 0 is also not that good as it shows:

  1. Company has the large amount of equity left in the reserve which is like no use because company is not using that money.
  2. And if company is not using its extra money to generate that extra money then how they are going to generate returns for the shareholders and how they are going to distribute the dividends to the shareholders.
  3. Ultimately the result can’t be expected from these fundamental as company don’t know how to use the cash reserve wisely.

What if Debt to equity ratio be negative?

D/E ratio, a negative value of D/E ratio denotes that the company’s shareholder’s equity gone in negative, like what could have been so worsen for the company that its shareholders will not get a single penny on behalf of their ownership in the company if company at this time liquidate itself.

We talk about low value of D/E ratio where the value has gone to the level of 1.0 but here the value has gone below 0, in which bracket to put these types of company.

What does it tells you?

It tells you about the financial stability of the company as:

  1. If the 5 year trend of D/E ratio decreasing then you should definitely check the fundamentals of the company, it will going to perform outstanding in the future.
  2. If the 5 year trend of D/E ratio is increasing then you should stay away from the company.
  3. If the 5 year trend of D/E ratio remains constant then you should check the shareholding pattern first, if it also remain constant then go through the projects on which the company is working if company is not working on any capital intensive project then it is advised to not invest in these types of companies.

Jet airways: Case study

Jet airways is one of the best case to understand the importance of D/E ratio, at one time company’s share is trading 500 rupee and the company keeps on increasing its debt because aviation industry requires hugh amount of cash to buy equipments necessary for the company.

For 1-2 year people believed with the mission of the company, where they see the fundamentals are not that good according to the amount of debt company is having.

But then people starts to loose confidence in the company, where they start booking profit and square off their position from the market.

And then slowly share comes down 300, then 150, then 75, then 30, then 10, and now share is trading about 1 rupees.

I share strong emotions to those investor who see great potential in the company even at 100, or at 50, I mean how can it be possible with such a huge leverages over the company.

The only thing which is increasing with the jet airways is their non-current liabilities, not their profit and nothing but the long term obligations.

When you see the last 5 year trend of the D/E ratio of the company, you will going to see that from 2:1 their D/E ratio gone to 6:1 like what the market could takeaway form this scenario nothing but not to invest in the company where the D/E ratio goes above 2:1.

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