The “Debt to Equity Ratio” Trap: Why Textbooks Are Lying to You About Debt

If you open 4 different financial management textbooks to the chapter on “Solvency Ratios,” you are likely to find three different formulas for the Debt-to-Equity (D/E) ratio.

1. Textbook A (The Banker’s View): Debt = Total Liabilities
2. Textbook B (The Traditionalist): Debt = Long Term Borrowings
3. Textbook C (The Modern Analyst): Debt = Short Term + Long Term Interest Bearing Debt
4. Textbook D (Class 12th Book): Debt = Long Term Debt + Long Term Provisions

It is a mess. And if you are doing a corporate valuation (DCF) or trying to calculate the Weighted Average Cost of Capital (WACC), this confusion isn’t just annoying. A wrong input here changes your Levered Beta, which changes your Cost of Equity, which eventually changes your target price.

So, what is the actual definition of Debt? Let’s go deep into the research, looking specifically at the “Textbook Wars” and how the “Dean of Valuation,” Professor Aswath Damodaran, resolves this.

The Three Schools of Confusion

1. The “Total Liabilities” School

Who says this? Many general accounting primers and banking-focused texts (e.g., British Business Bank guides). Link : –

https://www.british-business-bank.co.uk/business-guidance/guidance-articles/finance/what-level-of-debt-is-healthy-for-business

The Logic: A banker assessing bankruptcy risk cares about everyone the company owes money to, including suppliers (Accounts Payable) and employees.

Valuation Verdict: Wrong. In valuation, we treat Accounts Payable as “Working Capital,” not capital structure. You don’t pay interest on supplier bills (usually). Including them in your WACC calculation will artificially lower your cost of capital and inflate your valuation.

2. The “Long-Term Only” School

Who says this? Traditional Indian academic texts often lean this way. For example, Prasanna Chandra’s “Financial Management” often focuses on the Long-Term Debt-to-Equity ratio (ideal < 2:1) when discussing capital structure planning. When NCERT says the same that Debt in Debt Equity Ratio includes only Long term borrowing.

The Logic: Short-term debt fluctuates too much. They argue that capital structure should only measure “permanent” financing.

Valuation Verdict: Wrong. Many companies roll over short-term commercial paper essentially forever. If a company relies on short-term debt to fund operations permanently, ignoring it creates a “free lunch” in your valuation.

3. The “Provisions” Puzzle

Who says this? Intermediate texts like D K Goel, widely followed in Class 12th CBSE, has included long term provisions as part of long term debt for the calculation of Debt to Equity Ratio. DK Goel book snapshot as under : –

^{The Definitive Rule – What Prof Aswath Damodaran Says}

Professor Aswath Damodaran (NYU Stern) cuts through this noise with a simple principle: Consistency and Cost.According to his book Investment Valuation, “Debt” is not defined by accounting rules. It is defined by two characteristics:

1. Does it bear interest? (Explicit or Implicit)
2. Is it a contractual commitment where failure to pay leads to loss of control (bankruptcy)?

Here is exactly what you should include in your formula:

1. Interest-Bearing Debt (The Obvious Part) : Prof Damodaran’s Logic: It doesn’t matter if the debt matures in 6 months or 6 years. If it carries an interest cost, it belongs in your Cost of Capital.

2. Operating Leases (The Hidden Debt)

This is where 90% of people gets confused and historically stumbled. Damodaran argues strictly that Leases are Debt.

1. You have a contractual obligation to pay rent.
2. If you stop paying, you lose the asset.
3. The Fix: You must convert future lease payments into a “Debt” value (PV of Lease Commitments) and add this to your Total Debt.

CRUX : The Correct Formula for Corporate Valuation

If you are valuing a company or calculating WACC, throw away the simplified textbook formulas. Use this “Financial” Debt formula:

Total Debt = Short Term Borrowings + Long Term Borrowings + PV of Lease Commitments

Summary Table: What is Debt?