Debt to equity ratio is a long term solvency ratio that indicates the soundness of long-term financial policies of a company. It shows the relation between the portion of assets financed by creditors and the portion of assets financed by stockholders. As the debt to equity ratio expresses the relationship between external equity (liabilities) and internal equity (stockholder’s equity), it is also known as “external-internal equity ratio”.
Formula:
Debt to equity ratio is calculated by dividing total liabilities by stockholder’s equity.
The numerator consists of the total of current and long term liabilities and the denominator consists of the total stockholders’ equity including preferred stock. Both the elements of the formula are obtained from company’s balance sheet.
Example:
ABC 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 | |
Current liabilities: | |
Accounts payable | 2,900 |
Accrued payables | 450 |
Short-term notes payable | 150 |
——– | |
Total current liabilities | 3,500 |
Long-term liabilities: | |
6% Bonds payable | 3,750 |
——– | |
Total liabilities | 7,250 |
——– | |
Stockholders’ equity: | |
Preferred stock, $100, 6% | 1,000 |
Common stock, $12 par | 3,000 |
Additional paid-in capital | 500 |
——– | |
Total paid in capital | 4,500 |
Retained earnings | 4,000 |
——– | |
Total stockholders’ equity | 8,500 |
——– | |
Total liabilities and stockholders equity | 15,750 |
——– |
Required: Compute debt to equity ratio of ABC company.
Solution:
= 7,250 / 8,500
= 0.85
The debt to equity ratio of ABC company is 0.85 or 0.85 : 1. It means the liabilities are 85% of stockholders equity or we can say that the creditors provide 85 cents for each dollar provided by stockholders to finance the assets.
Significance and interpretation:
A ratio of 1 (or 1 : 1) means that creditors and stockholders equally contribute to the assets of the business.
A less than 1 ratio indicates that the portion of assets provided by stockholders is greater than the portion of assets provided by creditors and a greater than 1 ratio indicates that the portion of assets provided by creditors is greater than the portion of assets provided by stockholders.
Creditors usually like a low debt to equity ratio because a low ratio (less than 1) is the indication of greater protection to their money. But stockholders like to get benefit from the funds provided by the creditors therefore they would like a high debt to equity ratio.
Debt equity ratio vary from industry to industry. Different norms have been developed for different industries. A ratio that is ideal for one industry may be worrisome for another industry. A ratio of 1 : 1 is normally considered satisfactory for most of the companies.
Example
The Petersen Trading Company has total liabilities of $937,500 and a debt to equity ratio of 1.25. Calculate total stockholders’ equity of Petersen Trading Company.
Solution
Debt to equity ratio = Total liabilities/Total stockholder’s equity
or
Total stockholder’s equity = Total liabilities/Debt to equity ratio
= $937,500/1.25
= $750,000
April 12th, 2013 at 9:24 am
How To Calculate Gearing Ratio
Total Debt/Net Worth Meaning
April 13th, 2013 at 8:58 am
(1). A ratio that compares debts and equities of a company or the ability of a company to meet its debt related expenses (interest on borrowed funds etc.) is known as gearing ratio. Examples of gearing ratios are debt to equity ratio, capital gearing ratio, fixed assets to equity ratio and times interest earned ratio.
(2). Debt to net worth ratio (or total debt/net worth)and debt to equity ratio are the same.
June 11th, 2013 at 9:12 am
what if my debt to equity ratio is greater than 1, for example it is 40.6 or 4058%?
how do i explain it by comparing it with a debt – equity ratio of 0.7237 or 72.37%?
June 14th, 2013 at 5:58 am
Sophie, In your example you want to say 0.406 or 40.58%, not 40.6 or 4058%.
In first situation, creditors contribute $0.406 for each dollar invested by stockholders whereas in second situation, creditors contribute $0.7237 for each dollar invested by stockholders.
October 23rd, 2014 at 10:31 am
what does it mean as below?
debt equity ratio does not exceed 60:40
October 23rd, 2014 at 4:08 pm
Liabilities: 60
Stockholders’ equity: 40
February 4th, 2015 at 4:26 pm
excellent explanation
March 4th, 2015 at 10:13 pm
what if two companies debt to equity ratio are the same?
May 20th, 2015 at 1:34 am
What is the relationship of the two variables (i.e. debt and equity) to retained earnings?
May 24th, 2015 at 4:48 am
hi… lets say the debt to equity ratio for a company is 196.38%.. how do I explain this…
September 27th, 2015 at 7:48 am
how about i got the total is 10.88? so it will be 1088% .. how can i explain it pleasee help mee!!!!
October 8th, 2015 at 8:21 am
Hi…i think there is a misunderstanding here. What Accounting For Management last June 14 is saying is the debt to asset ratio and not debt to equity ratio. In debt to asset ratio, total asset is 100% while in debt to equity ratio, Total equity is 100%.
For example:
Debt to asset ratio of 40%. It means that 40% of the total asset is owned by external creditors while the 60% is owned by the company’s stockholders. If the answer is 100%, this means that all resources are financed by the company’s creditors and total equity is equal to “0”. This ratio will not exceed 100%.
Debt to equity ratio of 40%. This depicts that the company’s liabilities is only 40% compared to the company’s stockholders. This indicates that the company is taking little debt and thus has low risk. This ratio can exceed 100%. If the debt to equity ratio is 100%, it means that total liability is equal to total equity, thus, when you compute the debt to asset ratio, the answer will be 50%. However, if the answer for the debt to equity ratio is more than 100%, it means that total liability is higher than the company’s capital or total equity.
Thus, zawani md tahir, when you say that the debt to equity ratio is 10.88 or 1088%, the debt is 10 times of the company’s total equity. It indicates that the company has been heavily taking on debt and thus has high risk.
Hope my answer helps in explaining the difference between debt to asset ratio and debt to equity ratio. Both ratios pertains to the company’s leverage.
October 8th, 2015 at 3:47 pm
Thank you for your contribution Mary B.
November 12th, 2015 at 11:30 am
what does a debt to equity ratio of 0.4 mean.
I am try to work out the asset beta of a company
X plc has gearing ratio (debt :equity ) of 0.4 and the beat of its shares is 1.8.
The rate of corporation tax is 30%.
What is xplc asset beta.
Formula
Ba=Be(Ve/Ve+(Vd(1-.30)
December 10th, 2015 at 4:14 am
will secured and unsecured loans be added to
owners fund.. ?!?
January 22nd, 2016 at 7:02 am
What is Leverage? I read some where leverage of less than 10 is good.. is it same as debt equity ratio?