What is the Debt to Equity Ratio?
The debt to equity ratio is a liquidity financial ratio. It is a ratio that evaluates a company’s total debt to total equity.
In simple word, we can say that its obtained by dividing a company’s total liabilities by its shareholder equity.
The high value of D/E ratio represents that more creditor financing (bank loans) is used than investor financing (shareholders).
These numbers can be taken from balance sheet of a company’s financial statements.
This ratio is useful to evaluate a firm’s financial leverage. It’s essential for corporate finance.
It also shows the extent to which shareholders’ equity can fulfill a company’s obligations to creditors within the event of liquidation.
As the D/E expresses the relationship between external equity (liabilities) and internal equity (stockholder’s equity), that’s why, also referred to as “external-internal equity ratio”.
The Debt to Equity ratio is also called simply DER, D/E, risk ratio, and gearing ratio.
Advantage of Debt to Equity Ratio
- With the help of cash flow a firm can easily serve its debt obligations.
- Using the leverage the company wants to extend equity returns.
- By using debt instead of equity, the equity account is smaller and thus return on equity is higher.
- It provides greater protection to its money
Disadvantage of Debt to Equity Ratio
- It differs from industries to industries so consistency is not sure.
Debt to Equity Ratio Formula
What is Total Debt?
A company’s total debt is the sum of short-term debt, long-term debt, and other fixed payment obligations under normal operating cycles.
All current and non-current liabilities are not considered as debt. Some examples of things that are and are not considered debt in caculation.
- Drawn line-of-credit
- Notes payable (maturity within a year)
- Current portion of Long-Term Debt
- Notes payable (maturity more than a year)
- Bonds payable
- Long-Term Debt
- Capital lease obligations
Not considered debt:
- Accounts payable
- Accrued expenses
- Deferred revenues
- Dividends payable
Analysis and Interpretation of Debt to Equity Ratio:
A ratio of 1 (or 1: 1) implies that creditors and stockholders equally contribute to the assets of the business.
The value of D/E ratio is less than 1 ratio means it indicates that the portion of assets provided by stockholders is larger than the portion of assets provided by creditors.
A debt ratio of 0.5 implies there are half liabilities than there’s equity.
In other simple words, we can say, the assets of the company are funded 2-to-1 by investors to creditors.
This implies that investors own contribution about 66.6 percent of each dollar of assets of the company, while creditors only contributed 33.3 percent on the dollar.
The value of DER is greater than 1 means ratio indicates that the portion of assets provided by creditors is bigger than the portion of assets provided by stockholders.
This means that investors don’t want to fund the business operations because the firm isn’t performing well.
Due to lack of performance might also be the reason the company is seeking out extra debt financing.
Creditors usually like a low D/E ratio because a low ratio (less than 1) is the indication of greater protection to their money.
But stockholders wish to get have the benefit of the funds provided by the creditors therefore they might like a high this ratio.
D/E varies from industry to industry. Different norms are developed for various industries.
A ratio that’s ideal for one industry could also be worrisome for an additional industry. A ratio of 1: 1 is generally considered satisfactory for most of the companies.
Example of Debt to Equity Ratio:
Ratiosys company has applied for a loan. The lender of the loan requests you to compute the D/E ratio as a part of the long-term solvency test of the company.
The “Liabilities and Stockholders’ Equity” section of the balance sheet of Ratiosys company is given below:
Question: How to compute D/E of Ratiosys company.
= 7,250 / 8,500
The debt to equity ratio of Ratiosys company is 0.85 or 0.85: 1.
It clearly shows the liabilities are 85% of stockholders equity or we can say that the creditors provide 85 percent for each dollar given by stockholders to finance the assets.