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

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