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Debt Equity Ratio

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A corporation finances itself in two ways. The first is debt. This could take the form of bank loans or issuing a bond. The second is equity. This occurs through issuing equity, that is later traded on the stock market. The debt equity ratio tells us how much debt a firm uses relative to its equity. For example, suppose a firm has equal amounts of debt and equity. Then the debt equity ratio, or the total debt divided by total equity, is equal to one. If the debt equity ratio is larger than one, the firm has more debt than equity, and vice versa.

Typically, debt equity ratios vary by industry. Some industries, such as banks, tend to have relatively more debt, and higher debt equity ratios. Other industries, such as technology firms, tend to have less debt, and lower debt equity ratios. For this reason, it is best to compare debt equity ratios across firms in similar industries.

Companies with high debt equity ratios are riskier. This is because interest payments on debt must be made at regular intervals. If the firm is unable to generate enough cash to service its debt, it is at risk of bankruptcy. Companies with low debt equity ratios can more easily survive periods of poor performance.

Companies with high debt equity ratios also earn a high return on equity. This is because the value of equity is relatively small. Whenever you see a company with a high return on equity, it is important to check whether this is driven by high profit margins, or simply a higher debt equity ratio.

The Debt Equity Ratio Formula

The Debt Equity ratio is the total value of debt, or total liabilities, divided by the total value of equity. These values come from the balance sheet. Note that since no market variables (i.e. share price) are used, the debt equity ratio does not tell us whether a stock is cheap or expensive. An alternative calculation uses only long term debt instead of total debt. This is the long term debt to equity ratio.

Debt Equity Ratio = (total liabilities / total equity)

Calculating the Debt Equity Ratio, An Example

Suppose Baja Auto's most recent total liabilities is net income is Rs Cr 3,781. And their total equity is Rs Cr 17,034. Using our formula gives us a Debt Equity ratio of 0.22.

Bajaj Auto Debt Equity Ratio = Rs Cr 3,781 / Rs Cr 17,034 = 0.22

Comparing Debt Equity Ratio with Other Indicators

How does the Debt Equity ratio compare to other indicators, such as return on equity (ROE) or return on invested assets (ROA)? The debt equity ratio is closely linked to both of these indicators. In fact, there is a formula that links them all together:

ROE = ROA * (1 + Debt Equity Ratio)

The ROA is net income divided by total assets. The ROE is net income divided by total equity. Both ratios measure a firm's profitability. If you are buying a stock, you are an equity holder, so the ROE is what matters to you most. This formula helps us understand where a firm's ROE comes from.

It may be the case that a firm has a high ROE simply because it has a high debt equity ratio. If this is the case, the firm may be a high risk investment, and possibly should be avoided. On the other hand, if a firm has a high ROE because its ROA is high, this implies that the firm is highly profitable. It is not using excessive debt to bump up its ROE.

India's Most Attractive Companies Based on Debt Equity Ratio

In this live data section, you can find the stocks with the most attractive Debt Equity ratio.

AGC NETWORKS 31.4  More Info 
JAIPRAKASH ASSO 23.5  More Info 
KESORAM IND 19.1  More Info 
ASHOKA BUILDCON 18.9  More Info 
VODAFONE IDEA 16.1  More Info 
BHARTI AIRTEL 12.7  More Info 
NITCO 7.9  More Info 
SITI NETWORKS 3.7  More Info 
PARSVNATH DEV 3.3  More Info 

The Stock Screener runs on Equitymaster's own database, which comprises India's leading 489 companies.
*Data is consolidated wherever applicable

>> Here's the full list of India's most attractively valued companies

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