Debt to equity ratio is a long term solvency ratio that indicates the soundness of long-term financial policies of the company. It shows the relation between the portion of assets provided by the the stockholders and the portion of assets provided by creditors. It is calculated by dividing total liabilities by stockholder’s equity.
Debt to equity ratio is also known as “external-internal equity ratio”.
Formula:
The numerator consists of the total of current and long term liabilities and the denominator consists of the total stockholders’ equity including preferred stock.
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 creditors of ABC company provide 85 cents of assets for each $1 of assets provided by stockholders.
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.
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, your ratio is 0.406 or 40.6%, it means the stockholders provide 0.594 or 59.4% (1 – 40.6) funds to finance the total assets of the business.
In the second situation, stockholders provide 0.2763 or 27.63% (1 – .7237%) to finance the total assets of the company.
In the first situation, the contribution of stockholders is more than that of creditors to finance the total assets of the company. The company is therefore in a better position to finance its business by obtaining further debts from financial institutions or other appropriate resources.
The debt to equity ratio is less than 1 in the second situation. Therefore, the company may have to face problems in obtaining further debts from financial institutions as their liabilities to external parties are already more than their equities. Moreover, it will become difficult for the company to pay high interest charges associated with its highly leveraged capital structure during low profit periods that can ultimately lead the company towards bankruptcy.