What is the ‘Debt Equity Ratio’? Explanation with Example and Limitations. The debt to equity ratio is a financial, liquidity ratio that compares a company’s total debt to total equity. The debt to equity ratio shows the percentage of company financing that comes from creditors and investors. A higher debt to equity ratio indicates that more creditor financing (bank loans) is used than investor financing (shareholders). The Debt/Equity Ratio measures the riskiness of a company’s financial structure. The ratio reveals the relative proportions of debt and equity financing that a business employs. It is closely monitored by lenders and creditors, since it can provide early warning that an organization is so overwhelmed by debt that it is unable to meet its payment obligations. This is also a funding issue.
For example, the owners of a business may not want to contribute any more cash to the company, so they acquire more debt to address the cash shortfall. Or, a company may use debt to buy back shares, thereby increasing the return on investment to the remaining shareholders.
The formula for calculating D/E ratios can be represented in the following way:
Debt-Equity Ratio = Total Liabilities / Shareholders’ Equity
The result may often be expressed as a number or as a percentage.
How to Calculate the Debt to Equity Ratio
To calculate the debt to equity ratio, simply divide total debt by total equity. In this calculation, the debt figure should include the residual obligation amount of all leases. The formula is:
Long-term debt + Short-term debt + Leases
XYZ company has applied for a loan. The lender of the loan requests you to compute the debt to equity ratio as a part of the long-term solvency test of the company.
The “Liabilities and Stockholders’ Equity” section of the balance sheet of ABC company is given below:
|Liabilities and Stockholders’ Equity||Amount|
|Short-term notes payable||140|
|Total current liabilities||3380|
|6% Bonds payable||3,650|
|Preferred stock, $100, 6%||900|
|Common stock, $12 par||2,900|
|Additional paid-in capital||400|
|Total paid in capital||4,200|
|Total stockholders’ equity||7,700|
|Total liabilities and stockholders equity||14,730|
Required: Compute debt to equity ratio of XYZ company.
= 7,030 / 7,700
The debt to equity ratio of XYZ company is 0.91 or 0.91 : 1. It means the liabilities are 91% of stockholders equity or we can say that the creditors provide 91% for each dollar provided by stockholders to finance the assets.
Limitations of ‘Debt/Equity Ratio’
Like with most ratios, when using the debt/equity ratio it is very important to consider the industry in which the company operates. Because different industries rely on different amounts of capital to operate and use that capital in different ways, a relatively high D/E ratio may be common in one industry while a relatively low D/E may be common in another.
For example, capital-intensive industries such as auto manufacturing tend to have a debt/equity ratio above 2, while companies like personal computer manufacturers usually are not particularly capital intensive and may often have a debt/equity ratio of under 0.5. As such, D/E ratios should only be used to compare companies when those companies operate within the same industry.
Another important point to consider when assessing D/E ratios is that the “Total Liabilities” portion of the formula may often be determined in a variety of ways by different companies, some of which are not actually the sum of all of the company’s liabilities. In some cases, companies will only incorporate debts (like loans and debt securities) into the liabilities portion of the formula, while omitting other kinds of liabilities (unearned revenue, etc.).
In other cases, companies may calculate D/E in an even more specific way, including only long-term debts and excluding Short-term debts and other liabilities. Yet, “long-term debt” here is not necessarily a term with a consistent meaning. It may include all long-term debts, but it may also exclude long-term debts nearing maturity, which are then categorized as “short-term” debts. Because of these differentiations, when considering a company’s D/E ratio one should try to determine how the ratio was calculated and should be sure to consider other ratios and performance metrics as well.
Creditors view a higher debt to equity ratio as risky because it shows that the investors haven’t funded the operations as much as creditors have. In other words, investors don’t have as much skin in the game as the creditors do. This could mean that investors don’t want to fund the business operations because the company isn’t performing well. Lack of performance might also be the reason why the company is seeking out extra debt financing.
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