New accounting standards to change debt-equity ratio for companies

Currently there is no standard ideal debt to equity ratio for all companies

A number of companies may see their debt-equity ratio changing significantly once new accounting standards come into effect.

The new standards treat redeemable preference shares (RPS) – which are currently considered as part of a company’s equity – as debt.

Moreover, debt component of Optionally Converted Preference Shares (OCPS) will also be recognized in the balance sheet from now onwards.

Companies, which have a large section of its equity as RPS and OCPS, will witness alteration in their debt to equity ratio due to this change.

Debt to equity ratio – which is a measure of company’s financial leverage - is calculated by dividing its total liabilities (debt) by stockholders' equity.

Preference share is different than common stock as the owner of the former does not have any voting rights. Moreover, preference share owner also gets a fixed dividend from the company before the common stock dividends are paid out.

According to the Indian Accounting Standards 32 (Ind-AS 32), RPS will be considered as debt of the company whereas OCPS will be considered as a compound instrument with a significant debt component.

"The debt component in the OCPS can vary from contract to contract and requires detailed analysis,"¨said Ashish Gupta, Partner, Walker Chandiok & Co LLP.

Meanwhile, compulsory convertible preference shares (CCPS) will remain as equity of the company.

There is no standard ideal debt to equity ratio for all companies. It could vary from sector to sector, depending on risks and profitability among other things. For instance, a ratio of 2 may be taken as healthy for a car maker, while a software company may have it as low as 0.5.

The government has asked all companies, listed and unlisted, with a net worth of more than Rs 500 crore (Rs 5 billion), to start following these accounting standards for the accounting periods beginning April 1, 2016.