Debt to equity ratio shows you how debt is tied up in the owner’s equity. Please note, for this calculation only long term debt/liabilities are considered.
Debt is the amount of money company has borrowed from lenders to finance it’s large purchases or expansion. Lender has arranged finance for the company under the condition that its to be paid back at a later date, usually in installments over the years with interest. Interest is charged based on the level of risk that the lender takes.
Debt is shown on the liability side of balance sheet under the head long term or non-current liabilities. Interest incurred during the year is shown on the income statement.
Equity capital means the amount of money contributed by it’s owners or shareholders. In balance sheet, equity share capital measure the amount of money that company will have to return to the shareholders after paying back its obligations in case the company is liquidated. It’s also known as book value of the company.
You can calculate company’s equity share capital by taking out total liabilities from total assets.
Formula and analysis of debt to equity ratio
Debt to equity ratio is calculated by dividing company’s total liabilities by its shareholders equity capital. As discussed above, both the figures are available on the balance sheet of a company’s financial statements.
Here is the formula to calculate the D/E ratio:
Debt to equity ratio = long term liability / total equity share capital
This comparison will let you know the financial leverage of the company. Its measured and compared with industry standard to know up to what extent the company is financed for a long-term by its outsiders or lenders versus it’s owners in comparison to its competitors and industry.
If the ratio is high, it means the company is more capital intensive and the management should look for ways to reduce the long-term liability burden. In general, companies look for options to convert a portion of debt to equity. By doing so, the burden of debt and impact of interest as expenses to income statement will be reduced. As a result, the company will be more profitable by generating enough cash to fund its short term obligations.
Companies with high D/E ratio are always considered as highly vulnerable in difficult times.
You can use debt to equity ratio for personal finance by dividing total person liabilities of the individual by available capital. Capital in this case can be arrived by taking out liabilities from the total assets of the individual. Here is the formula:
Total personal liabilities / (All personal assets – liabilities)