Decoding Debt to Equity Ratio for Startups

In the first half of 2024, debt financing emerged as a key lifeline for Indian startups amid a challenging funding landscape. Total debt investments during this period reached $576 million—more than double the $285 million raised in the same period the previous year. This surge reflects a strategic shift as startups increasingly turned to debt to navigate the slowdown in traditional equity funding avenues.

H1 2024 saw 57 debt-only deals, amounting to $784 million, alongside multiple hybrid deals that combined equity and debt components. This trend accentuates the evolving dynamics of startup financing in India, where startups leverage debt financing to sustain their operations and control ownership during periods of economic uncertainty.

Interestingly, India’s external debt reached $663.8 billion as of March 2024, reflecting an increase of $39.7 billion compared to the previous year. 

In the broader corporate sector, industries like banking and infrastructure reported higher D/E ratios—often above 2—due to their capital-intensive operations. In contrast, tech companies maintained lower ratios, generally under 0.5, indicating a more conservative approach to leveraging debt.

Several companies have shown improvements in their debt management. For example, KRN Heat Exchanger and Refrigeration, a small-cap player in the HVAC industry, raised ₹3.42 billion through an IPO to fund a new manufacturing facility. The company reported a net income of ₹390.69 million for the year ending March 2024, up from ₹323.14 million the previous year. Its debt-to-equity ratio was 37%, reflecting balanced leverage.

Similarly, Ujaas Energy, a renewable energy firm, turned profitable with a net income of ₹38.15 million for the quarter ending June 2024. The company’s D/E ratio improved significantly over five years, dropping from 59% to 21%, showcasing enhanced financial management and stability.

These trends and examples highlight the importance of understanding the debt-to-equity ratio for startups and other companies in managing growth, capital structure, and financial stability in a changing economic environment.

‍

Understanding Debt to Equity Ratio

Definition of Debt to Equity Ratio

The debt-equity ratio (D/E), or the gearing ratio or risk ratio, is a financial metric that evaluates a company's financial leverage by comparing its total debt to its shareholders' equity. This ratio indicates how much debt a company uses to finance its assets relative to the equity provided by its shareholders. 

A higher D/E ratio suggests that a company relies more on borrowed funds, which can increase financial risk. Conversely, a lower ratio indicates a greater reliance on equity financing, reflecting potentially lower risk levels. This ratio varies across different industries; for instance, manufacturing companies exhibit higher debt levels, while technology firms generally maintain lower debt levels on their balance sheets.  

The D/E ratio indicates a company’s capital structure, revealing how much it relies on debt versus equity for financing. 

Calculation of Debt to Equity Ratio

This ratio is used by investors and analysts to assess a company's financial structure, indicating the proportion of financing that comes from debt versus equity. A balanced D/E ratio can indicate a company's ability to finance its growth while managing risk. It is generally calculated using the short formula: 

Debt to Equity Ratio (D/E) = Total Debt / Shareholders' Equity

Where:

• Total Debt includes both short-term and long-term liabilities.
• Shareholders' Equity represents the total equity capital shareholders invest plus retained earnings.

Many business owners use software tools to track and manage their D/E ratios and other financial metrics, preferably Microsoft Excel because it allows them to create custom financial models and automate calculations. It also allows businesses to maintain real-time tracking of their debt and equity positions, which enables better decision-making and financial planning. 

Example Calculation

For instance, consider a company with total liabilities of ₹3,000 crore and shareholders' equity of ₹15,000 crore. Its D/E ratio would be calculated as follows:

Debt-to-Equity Ratio = Total Liabilities/ Shareholders Equity = 3,000/ 15,000 = 0.2

This result indicates that for every ₹1 of equity, the company has ₹0.20 in debt. Conversely, if another company has total liabilities of ₹500 crore and shareholders' equity of ₹300 crore, the calculation would be:

Debt-to-Equity Ratio = 500/ 300 = 1.67

This suggests that for every ₹1 of equity, the company carries approximately ₹1.67 in debt.

Detailed Formula: For a more comprehensive analysis, the detailed formula for calculating the debt-to-equity ratio includes specific components of total debt, as outlined below:

Debt to Equity Ratio = Short-term Debt + Long-term Debt + Other Fixed Payment Obligations/ Shareholders Equity
Here’s a practical example of Route Mobile Ltd, a leading cloud communications platform service provider offering a communication platform as a service (CPaaS) solution. Route Mobile Ltd. serves enterprises, over-the-top (OTT) platforms, and mobile network operators (MNOs), offering diverse services. Their solutions include messaging, voice, email, SMS filtering, analytics, and monetization tools tailored to enhance communication and connectivity for clients across different sectors. The image below demonstrates the calculation of the debt-to-equity ratio using the detailed formula:

Balance Sheet of Route Mobile Ltd. (Consolidated Figures in Rs. Crores)

Step-by-Step Calculation:

1. Identify Total Debt: To calculate the total debt, we consider both borrowings and other liabilities:some text
   • Borrowings (March 2024): ₹378 crore.
   • Other Liabilities (March 2024): ₹934 crore.
   • Total Debt = Borrowings + Other Liabilities = ₹378 crore + ₹934 crore = ₹1,312 crore.
     
2. Identify Shareholders' Equity: Next, we calculate the total equity by summing the equity capital and reserves:some text
   • Equity Capital (March 2024): ₹63 crore.
   • Reserves (March 2024): ₹2,087 crore.
   • Total Equity = Equity Capital + Reserves = ₹63 crore + ₹2,087 crore = ₹2,150 crore.
     
3. Calculate the D/E Ratio: Now that we have both total debt and total equity, we can calculate the Debt-to-Equity Ratio:
   D/E Ratio = 1,312 crore / 2,150 crore = 0.61 

Route Mobile Ltd.'s debt-to-equity ratio as of March 2024 is approximately 0.61, indicating a balanced approach to using debt relative to equity. It also suggests that the company manages its financial leverage effectively while maintaining a healthy capital structure.

‍

Components of Debt-to-Equity Ratio

The D/E ratio indicates the balance between a company's funds obtained through debt (borrowed capital) and those provided by its shareholders (equity). Let’s uncover its components. 

Debt:  

• Short-Term Debt: Short-term debt includes financial obligations due within one year. It encompasses instruments such as lines of credit, notes payable, and any other liabilities that must be settled soon. Short-term debt is often used to finance day-to-day operations or manage working capital needs. 
• Long-Term Debt: Long-term debt refers to obligations that extend beyond one year. This includes bonds payable, long-term loans, and other forms of financing that require repayment over an extended period. 
• Other Fixed Payment Obligations: Companies may have different fixed payment obligations in addition to short- and long-term debts. These can include lease payments for equipment or property and any contractual commitments that require regular payments. 

Equity:

• Shareholders' Equity: This includes the value of equity capital (common stock, preferred stock) and retained earnings, representing the amount of money initially invested by shareholders and profits reinvested into the business over time.
• Additional Paid-In Capital: The excess amount from shareholders over the stock's par value also contributes to the equity portion.
• Reserves: These are funds set aside from profits for specific purposes, such as future expansion, debt repayment, or absorbing unforeseen losses. Reserves are typically included as part of equity in the calculation.

Understanding these fixed obligations helps startup owners evaluate a company's total debt profile and ability to meet all financial commitments.

‍

Importance of Debt-to-Equity Ratio

The Debt-to-Equity Ratio (D/E) is a crucial financial metric that serves different purposes for borrowers and lenders. Understanding its significance can provide valuable insights into a company's financial health and risk profile. 

For Startups:

1. Early-Stage Startups and Debt Management: Early-stage startups should maintain a low D/E ratio between 0.1 and 0.5. This range indicates a solid equity base, minimizing reliance on debt and making the business more appealing to investors who favor lower-risk profiles. Such a conservative strategy not only supports innovation but also alleviates financial pressure.
2. Mature Startups and Strategic Leverage: As startups mature, they can adopt a more moderate D/E ratio, generally falling between 0.5 and 1.5. This level reflects stable cash flows and profitability, allowing these businesses to use debt strategically for growth opportunities without jeopardizing their financial health.
3. High-Growth Startups and Risk Considerations: For high-growth startups, a higher D/E ratio—ranging from 1.5 to 3.0—may be justified as it signifies aggressive growth strategies and robust market positions. However, while leveraging debt can enhance growth potential, it also introduces risks such as liquidity constraints and increased financial obligations, requiring careful oversight to mitigate potential downsides.

For Borrowers:

1. Financial Leverage Assessment: For borrowers, the D/E ratio indicates how much debt is used to finance operations compared to equity. A higher ratio suggests greater reliance on borrowed funds, which can amplify returns during profitable periods and increase financial risk during downturns. Companies must carefully manage their leverage to meet repayment obligations without compromising operational stability.
2. Investment Decisions: A balanced D/E ratio can enhance a company's attractiveness to investors. A moderate ratio indicates that the firm is not overly reliant on debt, which can reassure shareholders concerned about financial distress. Conversely, an excessively high ratio might deter potential investors who perceive increased risk. 
3. Strategic Growth Opportunities: Understanding the D/E ratio helps borrowers identify their capacity for additional borrowing. A lower D/E ratio may indicate room for taking on more debt to fund expansion or new projects, while a higher ratio may signal caution in pursuing further debt financing.

For Lenders:

1. Risk Assessment
   Lenders closely examine the D/E ratio to evaluate the risk of lending to a company. A high D/E ratio suggests that a company is heavily leveraged, which may increase the likelihood of default if cash flows are insufficient to cover debt repayments. This heightened risk can lead lenders to impose stricter terms or higher interest rates.
2. Creditworthiness Evaluation
   The D/E ratio plays a significant role in assessing a borrower's creditworthiness. Lenders prefer companies with lower ratios, which indicates less reliance on debt financing and a more substantial equity base. A favorable D/E ratio can lead to better loan terms and conditions, making it easier for companies to secure funding.
3. Priority Claims in Liquidation
   In the event of liquidation, creditors have priority over shareholders regarding claims on assets. A high D/E ratio means more claims against the company's assets, which can be a red flag for lenders assessing their potential recovery in case of default.

Also Read: Introducing Recur Scale: Empowering Startups and SMEs with up to ₹100 Crores in Debt Financing