A Debt to Equity Ratio (D/E) is the financial ratio that indicates the debt and shareholders equity, which is used to finance the assets of a company. When talking about the ratio, in this case, it could sometimes be related to leverage, gearing or risk. These two elements are typically derived from an institution’s statement or balance sheet called book value.
Read on to this article and get to learn the formula and calculation of Debt to Equity Ratio.
What is Debt to Equity Ratio?
Debt to Equity Ratio is a form of financial ratio required by an institution’s or individual to be able to manage various activities. To understand better the Debt to Equity Ratio, you need to understand the financial structure of the firm. Debt to Equity Ratio is necessary because is used to calculate the equity better.
The Debt to Equity Ratio equation is significant on how any company runs its finance and assets as it is the formula used to calculate the variables, as well as the variances that will help reduce the errors that are likely to occur during calculations. As with each company using Debt/Equity Ratio, it is necessary to consider how the industry operates. This is because each industry has its own way of capital operation, and later end up using the money in different ways.
What is the Debt to Equity Ratio formula?
The Debt-Equity Ratio is calculated using the following formula:
Debt/Equity Ratio=Total liabilities/Shareholders Equity
In simple terms, the ratio will be debt divided by equity. However, depending on the interpretation that has been used, the description of debt can differ. In essence, of all these explanations, a ratio can take various forms including:
- Total Liabilities/Equity
- Long-term Debt/Equity
The results found after the calculation is always expressed as either a percentage or number.
How to calculate Debt to Equity Ratio
When you survey the different industries in the market, you realize each has its own equity ratio benchmark. Some firms are likely to utilize more debt financing as compared to others. Generally, the company’s assets are funded 2:1 by investors to creditors. A good example would be that the investors own 66.6 of every cent getting into the firm, while creditors only own 33.3 cents of the money.
Institutions with higher Debt to Equity Ratio are said to be riskier to both the investors and creditors, as compared to those with a lower ratio. A Debt to Equity Ratio that is lower in any business indicates that it is financially stable. Unlike equity, any debt must be paid back to the lender. Equity financing is way cheaper because, with debt financing, there is the requirement for regular interest payments or debt servicing.
Companies that leverage high amounts of debts may fail to pay back. Creditors, on the other hand, believe a higher Debt to Equity Ratio is not good since it means the financiers have not invested in enough capital as compared to what the creditors have put in. Another explanation for this could be that sponsors are not funding any ongoing operation in the company since the performance is minimal.
Let us say company X has $100,000 of bank lines of credit and a $500,000 mortgage on its property. If the shareholders in this company have invested a total of $ 1.2 million, this is how you go about calculating the Debt to Equity Ratio:
$ 100,000+$ 500,000 divide by $ 1,200,000
A Debt to Equity Ratio of 1 implies that creditors and investors have an equal amount of shares in the business assets.
When more debt is used in financing the operations within an institution, the company will be able to generate more earnings, as to when it did not have financing from outside. Hence, if higher profits were being realized, then it means the shareholder benefits are being spread equally among the shareholders within the company.
Total Debt to Equity Ratio for personal finances
There are instances when Debt/Equity (D/E) Ratio can be applied to personal financial statements. In this case, it will be called personal debt/equity ratio. In this instance, equity refers to the total value of an individual’s liabilities or debt and the total value of an individual’s assets. Hence the formula for personal Debt-Equity Ratio can be calculated as:
Debt/Equity Ratio for personal finances =Total personal debt/(total assets-total personal debt)
A small amount of personal Debt/Equity Ratio is applied to a loan when an individual wants it for various purposes. When talking about personal financial ratios, this form of financing is significant to a lender since it gives the lender some sense of financial stability when borrowing, when borrowing a loan.
Any entity with a history of high personal Debt/Equity Ratio is not likely to give the candidate so much confidence that the loan could be repaid at the required time. Contrary to the aforementioned, where a person with a low Debt/Equity Ratio has a lower risky rate since the loan can be paid back seamlessly.
- Ghana's debt hits an amazing ¢137 billion
- We shall pay all debts in the energy sector
- Ghana Crosses Threshold On HIPC