- Debt to equity ratio is a type of a gearing ratio
- It used to evaluate a company’s financial leverage
- It can be calculated with the information provided in a company’s balance sheet
- 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
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.