The formula that we could use to calculate debt to equity ratio is: Debt to equity ratio = Total Debt / Total Equity. Debt refer to kind of liabilities including short term and long term liabilities. For example, short term loan, account payable, noted payable, interest payable, and long term loan. We need to include them all. Total equity here include all kind of equity items that report in balance sheet. For example, ordinary share, preferred share, retain earning, accumulated others comprehensive income etc. For easy calculation, you can also use this equation, Assets = liabilities + Equity, to find equity balance.
- 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:
Example, the following is the list of debt and equity that extract 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%
Based on calculation above, we noted that the entity’s debt to equity ratio is 115%. This ratio appear that the entity has high debt probably because of the entity financial strategy on obtaining the new source of fund is favorite to debt than equity. As we know, debt and equity are the two main method that the entity could use to obtain the new fund for new project. However, high debt might not good for the shareholders since the company has to pay for interest expenses first before paying shareholders. High debt might also not good for the entity since soon it will face financial difficulty.