The debt to equity ratio is one of the liquidity ratios used to assess the liquidity problems of an entity by using total debts to total equity over a period of time. Debt to equity ratio concerns all debt, short-term and long-term debt over the total equity, including share capital, retain earning, and others.
For example, the entity is facing high potential contingent liabilities. Contingent Liabilities are a type of potential liabilities due to current obligations ande outside the balance sheet items.
Calculation of the Debt to Equity Ratio is solely dependent on the balance sheet items. Therefore, this ratio does not solely represent the current financial situation of the entity.
The above is its concept and next is the formula and example.
Now let move to the formula,
Debt to Equity Ratio = Total Debt / Total Equity
- Total Debt here includes all types of debt, both short-term and long-term debt. The Short-term is quite simple. They are Account Payable, Accrual, Current Tax Liabilities, and Others Short-term debt. Long-term debt includes long-term loans, deferred tax liabilities, preferred shares, and other long-term debt.
- Total Equity here refers to the items like ordinary share, paid-up share capital, share outstanding, and retain earning.
Now let me move the example of how to calculate the Debt to Equity Ratio.
For example, at the end of 31 December 2016, ABC company, the company operating in manufacturing, has financial information.
Extracted from ABC’s Financial Statements.
Total Debt = USD10,00,000
Total Equity = $9,000,000
Now, let calculate the debt ratio together.
As the formula, Debt to Equity Ratio = Total Debt / Total Equity
Therefore the answer is 10,000,000 / 9,000,000 = 1.11
This ratio also concerns the financial gearing of an entity. The ratio wants to assess how the total equity could settle total debts. There is no role to say about the good ratio and how much the alert situation is.
, the entity is financially secure when the ratio is below one. Higher than one means that total debt at the end of the period smaller than total equity at that time.
The higher equity note that the entity could pay all kinds of debt, short-term and long-term debt, using its own equity. However, most of the time, liquidity does not look only at these sides.
The debt to Equity Ratio is just one side of liquidity. Moreover, financially secure does not mean the entity does not have a liquidity problem.
Base on the calculation above, the ratio is higher than one. This means the company is financially not secure. This ratio is normally review and analyzed by the debtor and creditor.
Sometimes it is analyzed by the current customer as well as suppliers. The supplier is concern about how the company could pay its credit sales, and customers analyze because they want to know how long the company could run its operation.
Once the ratio is over one, the financial controller needs to make sure that this ratio is going down to easily obtain the loan or extend the credit term from its suppliers.