The D/E ratio is thus, the ratio of the amount invested by outsiders to the amount invested by the owners of the business.
It is an important tool of financial analysis to appraise the financial structure of a firm. It has important implications from the view point of creditors, owners & the firm itself.
A high ratio shows a large share of financing by the creditors of the firm while a lower ratio implies smaller claim by creditors. It indicates the margin of safety to creditors.
For ex: If the D/E ratio is 2:1, it implies for every rupee of outside liability, the firm has two rupees of the owner’s capital. Hence there is a safety of margin of 66.67% available to the creditors of the firm. Conversely if the D/E ratio is 1:2, it implies low safety of margin for the creditors.
A high D/E ratio has equally serious implications from the firm’s point of view. It would affect the flexibility of operations of the firm, restrict the borrowings etc. the shareholders would however gain in 2 ways:-
i) with a limited stake they would be able to retain control of the firm.
ii) The returns would be magnified.
A low D/E ratio would have just the opposite implications.