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”.
The numerator consists of the total of current and long term liabilities and the denominator consists of the total stockholders’ equity including preferred stock.
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|
|Short-term notes payable||150|
|Total current liabilities||3,500|
|6% Bonds payable||3,750|
|Preferred stock, $100, 6%||1,000|
|Common stock, $12 par||3,000|
|Additional paid-in capital||500|
|Total paid in capital||4,500|
|Total stockholders’ equity||8,500|
|Total liabilities and stockholders equity||15,750|
Required: Compute debt to equity ratio of ABC company.
= 7,250 / 8,500
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.