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Debt-Equity Ratio

This ratio expresses the relationship between total liabilities (also called external equities) and the owner’s funds or equity (also called internal equities). It is calculated as:

Debt-Equity Ratio      =     Total Debts (Outside Liabilities) / Owner’s funds

or                                                             or

Debt-Equity Ratio      =     External Equities / Internal Equities

Components: Total Debts (or outside liabilities) or external equities consist of short-term as well as long-term liabilities, e.g., creditors, bills payable, outstanding expenses, debentures and long-term loans (secured and unsecured). The owner funds or internal equities consist of equity share capital plus reserves and surplus plus preference share capital minus fictitious assets. This ratio indicates the proportion of funds provided by the owner / shareholders as against the outsiders. In other words, it is the ratio fo the amount invested by outsiders to the amount invested by owners of the business firm. It is necessary to clarify as to why the current liabilities are included in the total debts for calculating this ratio? There is no doubt that current liabilities are short-term in nature and the ability of the firm to pay them is reflected in the liquidity ratios, that is, current ratio and quick ratio. Even then they are part of total outside laities to reasons: (i) The fixed amount of current liabilities is always in use so that they are available on a long-term basis. (ii) Some current liabilities like bank overdraft or short-term bank credit, are available year after year on more or less a permanent basis and hence they automatically become part of the long-tem debt. (iii) In the event of liquidation, the current liabilities like the long-term creditors have a prior claim on the assets of the business enterprise. (iv) The short-term creditors exert as much pressure on the management as do the long-term creditors. (v) The term debts does not make any distinction between short-term debt and long-term debt. It is thus very clear that the non-inclusion of short-term  liabilities in calculating debt-equity ratio would give incorrect or even misleading results.

However some authors do not agree with this view. They interpret the term debt as long term debts only. It is, therefore, suggested that the examiner must provide a clear hint to the students as to the meaning of the term debt. otherwise both the interpretations should be accepted. In no case the students are penalized for different views of the author(s). Interpretation: A high debt-equity ratio shows the contribution of more funds by the outsiders than the owners and hence a larger claim on the assets fo the firm. A low debt-equity ratio means smaller claim on the assets of the firm. A low debt-equity ratio means smaller claims fo the outsiders on the assets. The debt-equity ratio indicates the margin of safety for the creditors. For example if debt-equity ratio is 1:2, it means for every one rupee claim of outsiders, the business entity has two rupees of owners capital. There is thus a safety margin of 50% . The lower the debt equity  ratio, the higher the degree of protection available to creditors. A higher debt-equity ratio means less investment by the owners and obviously a danger signal for the creditors. It is also not good for the firm too. For example, the firm will have to bear a heavy burden of interest will find it difficult to raise more loans in future. However, the shareholders payments especially when the profits decline. Moreover the business entity will find it difficult to raise more loans in future. However, the shareholders stand to gain from the high debt-equity ratio. The reasons are: (i) They can retain the control of the company with less contribution, (ii) The return on their investment will increase. The debt carries a fixed rate of return and if the firm is able to earn more than what is payable on loan, the benefit will go to the owners. This called trading on equity. A low debt equity ratio has the opposite results. The creditors have sufficient safety margin because of more funds provided b the owners. The business enterprise has less burden of interest payments and can raise more funds in future without much difficulty. However the shareholders are not entitled to the benefits of trading on equity.

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