Debt-to-Equity Ratio

Debt-to-Equity ratio is the ratio of total liabilities of a business to its shareholders' equity. It is a leverage ratio and it measures the degree to which the assets of the business are financed by the debts and the shareholders' equity of a business.

Formula

Debt-to-equity ratio is calculated using the following formula:

Debt-to-Equity Ratio = Total Liabilities
Shareholders' Equity

Both total liabilities and shareholders' equity figures in the above formula can be obtained from the balance sheet of a business. A variation of the above formula uses only the interest bearing long-term liabilities in the numerator.

Analysis

Lower values of debt-to-equity ratio are favorable indicating less risk. Higher debt-to-equity ratio is unfavorable because it means that the business relies more on external lenders thus it is at higher risk, especially at higher interest rates. A debt-to-equity ratio of 1.00 means that half of the assets of a business are financed by debts and half by shareholders' equity. A value higher than 1.00 means that more assets are financed by debt that those financed by money of shareholders' and vice versa.

An increasing trend in of debt-to-equity ratio is also alarming because it means that the percentage of assets of a business which are financed by the debts is increasing.

Example

Calculate debt-to-equity ratio of a business which has total liabilities of $3,423,000 and shareholders' equity of $5,493,000.

Solution
Debt-to-Equity Ratio = $3,423,000 / $5,493,000 ≈ 0.62

by Irfanullah Jan, ACCA and last modified on

XPLAIND.com is a free educational website; of students, by students, and for students. You are welcome to learn a range of topics from accounting, economics, finance and more. We hope you like the work that has been done, and if you have any suggestions, your feedback is highly valuable. Let's connect!

Copyright © 2010-2024 XPLAIND.com