The formula that we could use to calculate the debt to equity ratio is,
Debt to Equity Ratio = Total Debt / Total Equity.
Debt refers to total all kinds of liabilities of the company that it is holding, including short-term and long-term liabilities where you could find it is the balance sheet.
Short-term liabilities or current liabilities including
- Short-term loans
- Account payable,
- Noted payable
- Interest payable
Long term liability or non-current liabilities including
Long-term loans. We need to include them all. Total equity here consists of all kinds of equity items that report in the balance sheet.
For example, ordinary share, preferred share, retained earnings, accumulated others comprehensive income, etc. You can also use this equation, Assets = liabilities + Equity, to find equity balance for easy calculation.
Here is a detail of each item:
- 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 others liabilities.
- Total equity here included all kind 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 others equity items.
Calculate debt to equity ratio:
For example, the following is the Debt and equity list extracted from entity financial statements at the end of 31 December 2016.
Here are debt:
- Noted payable = 30,000
- Account payable = 40,000
- Short term debt = 100,000
- Long term debt = 200,000
Here are the equity:
- Ordinary share = 200,000
- Preferred share = 100,000
- Retain earning = 20,000
Now let calculate debt to equity ratio:
Debt to equity ratio = Total Debt / Total Equity = 370,000/ 320,000 =1.15 time or 115%
We noted that the entity’s Debt to equity ratio is 115% based on the calculation above. This ratio appears that the entity has high Debt probably because the entity’s financial strategy on obtaining the new source of funds is favorite to Debt than equity.
As we know, Debt and equity are the two main methods that the entity could use to obtain the new fund for the new project.
However, high Debt might not be suitable for the shareholders since the company must first pay interest expenses before paying shareholders. High Debt might also not be ideal for the entity since soon it will face financial difficulty.