Not logged in, please login to view portfolio!

Blog Stocks

Long Term Debt to Equity: Concept Definition, Formula & Explanation

Sarmaaya Desk
Sarmaaya Content Team

Key Takeaways

  1. Debt to equity ratio is a type of a gearing ratio
  2. It used to evaluate a company’s financial leverage
  3. It can be calculated with the information provided in a company’s balance sheet
  4. Debt to equity ratio is used to help analysts and investors understand the extent to which the company is using debt to leverage their assets
  5. A higher Debt to Equity ratio indicates a greater risk

What is Debt to Equity Ratio?

It is a type of a gearing ratio and is used to evaluate a company’s financial leverage. It is calculated by dividing a company’s total liabilities with its total shareholder equity.

The D/E ratio is more commonly used in corporate finance as it measures the degree to which an organization or accompany uses debt to finance its operations compared to their own funds. To understand better, it describes shareholders’ ability to use their equity to cover all of their outstanding debts in case of a business downturn.

How to Calculate it?

The formula to calculate the D/E ratio and the example for its use is as follows:

Debt to Equity = Total Liabilities / Total Shareholders’ Equity

The relevant figures for this formula can easily be found in the company’s balance sheet;

For example. Company X has $100,000 in liabilities and $ 20,000 in equity. By the formula Debt/Equity, the ratio will be equal to 5.

This shows that company X has a debt of $.5 for every $ 1 of equity. This indicates that Company X is highly leveraged which means the company is at higher risk which can result in loans rejection from the bank. However, further investigation would be needed to make a final conclusive decision.

Understanding Debt to Equity

Debt to equity ratio is used to help analysts and investors understand the extent to which the company is using debt to leverage their assets. A higher Debt to Equity ratio indicates a greater risk because it means that the company has taken an aggressive approve in financing its growth through debt.

It is, however, important to note that if a lot of debt is used to finance growth, it is possible for the company to generate greater earnings which otherwise would not have happened. If the company’s earning are increased because of leverage than the cost of debt itself i.e its interest then it is expected for shareholders to reap some benefit. However, if the cost of debt is greater than the earnings generated, then it is possible for share values to decline.

Debt to Equity ratio is impacted by the changes that cover in a company’s long-term debt and assets because they are usually larger accounts than the ones in short debts and assets. So if an investor wants to understand a company’s ability to meet short term debt and leverage that must be covered in a period of a year or less, other ratios must be used.

Like with any other ratio, Debt to equity ratio must also be used in comparison to the industry within which the company is operating and the comparison must only be carried between the companies operating within the same industry. This is because different industries have different capital needs what’s common for one industry may not be for the other. So to keep objectivity, we make a comparison of the companies from within the same industry.

 




Related articles

My Watchlist

Not logged in, please login to view watchlist!

Sarmaaya was founded in 2017 by Laeeq Ahmad, and created in response to the non-existence of a web-based platform that could audit traders globally and at the same time; enable traders to share their knowledge with people interested in their strategies.

Disclaimer
abcData (Pvt) Limited (Sarmaaya) is a Pakistan Stock Exchange (PSX) authorized data redistributor. Sarmaaya & CS Solutions (Pvt.) Limited (CS) do not guarantee the timeliness, accurateness, or completeness of any data or information on the website. Sarmaaya & CS makes no warranties, express or implied, as to Sarmaaya & CS or any data or values relating thereto or results to be obtained therefrom, and expressly disclaims all warranties of merchantability and fitness for a particular purpose with respect thereto. To the maximum extent allowed by law, Sarmaaya & CS, its licensors, and their respective employees, contractors, agents, suppliers and vendors shall have no liability or responsibility whatsoever for any injury or damages – whether direct, indirect, consequential, incidental, punitive or otherwise – arising in connection with Sarmaaya & CS or any data or values relating thereto – whether arising from their negligence or otherwise. Nothing in the website shall constitute or be construed as an offering of financial instruments or as investment advice or investment recommendations (i.e., recommendations as to whether or not to “buy”, “sell”, “hold”, or to enter or not to enter into any other transaction involving any specific interest or interests) by Sarmaaya & CS or a recommendation as to an investment or other strategy by Sarmaaya & CS. Data and other information available via the website should not be considered as information sufficient upon which to base an investment decision.