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Debt / Equity Ratio

Debt / Equity Ratio give us information about

the Capital Structure of the company.

FORMULA

    Debt / Equity Ratio  =

    CTotal Liabilities


    Shareholder's Equity

     

EXAMPLE

Debt / Equity ratio uses figures as presented in Statement of Financial Position. Both the figure of total liabilities and Equity is presented on the face of Statement of Financial Position.

Debt / Equity Ratio  =

1,182,670 + 791, 840


3,743,995

Debt / Equity Ratio  =

52.73 %

Data used in calculating ratio is extracted from Hypothetical Financial Statements. (See Hypothetical Financial Statements used in calculation).

 

MEASUREMENT UNIT

Debt / Equity ratio is measured in Percentages.
Using the above example out of company’s total capital 52.73% is financed by debt.

INTERPRETATION

How to interpret the ratio

Debt / Equity Ratio give us information about company’s ability to satisfy the long term obligations (loans / borrowings) of the company. This ratio shows the capital structure of the company.

The business normally have two sources of financing; one is equity i.e. acquiring funds from share holders and returning them profits for these funds, other is debt i.e. acquiring funds from lenders and returning them interest for these funds (also the principal as well after the period agreed). For a successful business there should be an optimizing balance between debt and equity since both have some advantages and disadvantages.

Funds in the form of debt are cheap as interest paid on them is tax deductible expense whereas funds from equity are somewhat expensive as return to shareholders is distributed from net of tax profits. However “Business Decision Makers” determine the best mix of Debt / Equity depending on every individual case.

Lower percentage of Debt / Equity ratio is beneficial for company since debt is secured by the equity and thus lenders will have confidence.
If ratio is higher than 50%, the company is highly geared which means that lenders will be reluctant in extending the loan facility. Perhaps they will provide loans on rigid terms and conditions.

Users’ needs addressed by the ratio

Lenders are most common users of long term solvency ratios as they have forwarded the long term loan to company and they want to ensure that company can pay yearly interest as well as principal back to lenders.

Management monitors the Debt / Equity ratio to avoid long term creditworthiness problems as well as having optimal mix of debt and equity in order to boost the business.

(You must have an understanding of users’ needs of financial statements; please refer the topic 1- financial statement users for details).

 

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