Debt to Equity Ratio

See Also: Financial Ratios Debt Ratio Debt Service Coverage Ratio (DSCR) Free Cash Flow

Debt to Equity Ratio Definition

The debt to equity ratio definition is an indication of management’s reliance to finance its asset on debt rather than on equity. It measures a company’s capacity to repay its creditors. This ratio varies with different industry and company. Comparing the ratio with industry peers is a better benchmark.

Debt to Equity Ratio Meaning

The debt ratio means an indication of the gearing level of a company. A high ratio means that a company may be over-leveraged with debt. This can result in high insolvent risk since excessive debt can lead to a heavy debt repayment burden. However, when a company chooses to rely largely on equity, they may lose the tax reduction benefit of interest payments. In a word, a company must consider both risk and tax issues to get an optimal debt to equity ratio explanation that suits their needs.

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Debt to Equity Ratio Formula

Use the following debt to equity ratio formula:

Debt to equity = total debt / total equity

Calculation of Debt to Equity Ratio

Debt to equity ratio calculations are a matter of simple arithmetic once the proper information is complied. Debts will include both current liabilities and long term liabilities. Equity will include goods and property your business owns, plus any claims it has against other entities. For example, a company has $10,000 in total debt, and $40,000 in total shareholders equity.

Debt to equity = 10,000 / 40,000 = 0.25

This means that a company has $0.25 in debt for every dollar of shareholders’ equity.

Debt to Equity Ratio Example

For example, Shari has started a residential real estate company which has grown to success. Though the market is tough, Shari has protected her cash account in order to deal with what the future holds. Shari now needs to perform debt to equity analysis to make sure she has not become over-leveraged in her company. This could cause problems with bank loans, her company free cash flow, and more. Shari contacts her controller for debt to equity accounting questions. She knows that there is no debt to equity calculator, so she is willing to wait for some concrete results.

$10,000 in total debt and $40,000 in total shareholders equity.

Debt to equity = $10,000 / $40,000 = $0.25

Her controller finds that she is in perfect standing. Her company, though near its limit, does not have too much debt. It has enough cash to survive common issues which face the residential real estate industry. She is satisfied that she has followed the path of a responsible business owner. Because she is so used to putting out fires, she is content with the status quo of her company’s regular monthly profits. Shari looks forward to her next quarter.

Resources

For statistical information about industry financial ratios, please click the following website: www.bizstats.comand www.valueline.com. If you want to add more value to your organization, then click here to download the Know Your Economics Worksheet.