Debt to Equity Ratio (Definition, Formula, Example, and Analysis)

Definition:

The debt to equity ratio is the debt ratio that is used to measure the entity’s financial leverages by using the relationship between total liabilities and total equity at the balance sheet date.

Bankers, creditors, shareholders normally use the debt to equity ratio, and investors to provide the loan, extend credit terms, and an investment decision.

There is no specific rule to say how much is the good debt to equity ratio and how much is bad. However, if the balance is 100%, the entity could use all of its equity to pay off its debt.

Formula:

The debt to equity ratio can be calculated by dividing total debt by total equity at the end of the period. These total debt and total equity figures can take from the balance sheet.

  • Total liabilities here include both current and non-current liabilities that report in the balance sheet at the reporting date. They are including short term loan, long term loan, account payable, noted payable, tax liabilities, accrual expenses, salaries payable, unearned revenue, and other liabilities.
  • Total equity here included all kinds of equity items that report the balance sheet on the same period of liabilities. These items including ordinary shares, preferred shares, retain earning, accumulated gain or loss, and other equity items.

Example:

For example, ABC company has the following financial information as of 31 December 2016,

  • Short term loan = 100,000 USD
  • Long term loan = 40,000 USD
  • Account payable = 30,000 USD
  • Noted payable = 40,000 USD
  • Tax liabilities = 50,000 USD
  • Accrual expenses = 60,000 USD
  • Salaries payable = 30, 000 USD
  • Unearned revenue = 30,000 USD
  • Others liabilities = 50,000 USD
  • Equity = 500,000 USD
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Calculate debt to equity ratio of ABC company.

Answer:

Based on the information above, we got

  • Total liabilities = 900,000 USD
  • Total equity = 500,000 USD

Analysis:

As mentioned above, the debt to equity ratio is used to assess the entity’s financial leverage and liquidity problems. This ratio goes up and down is depending on the entity’s financial strategy.

For example, the entity plan to increase its operations by increasing the production line. This increase requires new sources of fund. In this case, the entity might raise the fund through a loan or equity.

High debt compared to equity will not only increase the ratio soon, but the entity’s financial gearing will also increase, and this might affect shareholders.

The effect to shareholders is through dividends since part of the entity earnings have to pay interest expenses.

There are many ways that we can use to improve this ratio. The first is to raise new funds from selling the new share. This will help the entity have some funds to settle the debt, subsequently improving the ratio.