What is Debt to Equity Ratio?
Debt to Equity Ratio is calculated by dividing the shareholder equity of the company to the total debt thereby reflecting the overall leverage of the company and thus its capacity to raise more debt
By using the D/E ratio, the investors get to know how a firm is doing in capital structure; and also how solvent the firm is, as a whole. When an investor decides to invest in a company, she needs to know the approach of a company.
If the total liabilities of the company are higher compared to the shareholders’ equity, the investor would think whether to invest in the company or not; because having too much debt is too risky for a firm in the long run.
If the total liabilities of the company are too low compared to the shareholders’ equity, the investor would also think twice about investing in the company; because then, the company’s capital structure is not conducive enough to achieve financial leverageFinancial LeverageFinancial Leverage Ratio measures the impact of debt on the Company’s overall profitability. Moreover, high & low ratio implies high & low fixed business investment cost, respectively. read more. However, if the company balances both internal and external financeExternal FinanceAn external source of finance is the one where the finance comes from outside the organization and is generally bifurcated into different categories where first is long-term, being shares, debentures, grants, bank loans; second is short term, being leasing, hire purchase; and the short-term, including bank overdraft, debt factoring.read more, then maybe the investor would feel that the company is ideal for investment.
Pepsi Debt to Equity was at around 0.50x in 2009-1010. However, it started rising rapidly and is at 2.792x currently. It looks like an over-leveraged situation.
Debt to Equity Ratio Formula
Debt to equity is a formula that is viewed as a long term solvency ratio. It is a comparison between “external finance” and “internal finance.”
Let’s have a look at the formula –
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For eg:
Source: Debt to Equity Ratio (wallstreetmojo.com)
In the numerator, we will take the “total liabilities” of the firm; and in the denominator, we will consider shareholders’ equity. As shareholders’ equity EquityShareholder’s equity is the residual interest of the shareholders in the company and is calculated as the difference between Assets and Liabilities. The Shareholders' Equity Statement on the balance sheet details the change in the value of shareholder's equity from the beginning to the end of an accounting period.read more also includes “preferred stock,” we will also consider that.
Example
Let’s take a simple example to illustrate the debt-equity ratio formula.
Youth Company has the following information –
- Current Liabilities – $49,000
- Non-current Liabilities – $111,000
- Common Stocks – 20,000 shares of $25 each
- Preferred Stocks – $140,000
Find out the debt-equity ratio of Youth Company.
In this example, we have all the information. All we need to do is to find out the total liabilities and the total shareholders’ equity.
- Total liabilities = (Current liabilities + Non-current liabilities) = ($49,000 + $111,000) = $160,000.
- Total shareholders’ equity = (Common stocks + Preferred stocks) = [(20,000 * $25) + $140,000] = [$500,000 + $140,000] = $640,000.
- Debt equity ratio = Total liabilities / Total shareholders’ equity = $160,000 / $640,000 = ¼ = 0.25.
- So the debt to equity of Youth Company is 0.25.
In a normal situation, a ratio of 2:1 is considered healthy. From a generic perspective, Youth Company could use a little more external financing, and it will also help them in accessing the benefits of financial leverage.
Uses
The formula of D/E is the very common ratio in terms of solvency.
If an investor wants to know the solvency of a company, debt to equity would be the first ratio to cross her mind.
By using debt to equity, the investor not only understands the immediate stance of the company; but also can understand the long-term future of the company.
For example, if a company is using too little external finance, through debt to equity, the investor would be able to understand that the company is trying to become a whole-equity firm. And as a result, the firm wouldn’t be able to use the financial leverage in the long run.
Calculator
You can use the following formula of D/E Ratio Calculator
| Total Liabilities | |
| Shareholders' Equity | |
| Debt to Equity Ratio Formula | |
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Calculate Debt Equity Ratio in Excel
Let us now do the same example above in Excel.
This is very simple. You need to provide the two inputs of total liabilities and the total shareholders’ equity.
You can easily calculate the ratio in the template provided.
Here, First, We will find out the Total Liabilities and shareholders’ Equity.
Now We will calculate the Debt Equity Ratio using the formula of debt to equity ratio.
You can download this template here – Debt to Equity Ratio Excel Template.
Debt to Equity Ratio Formula Video
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This has been a guide to Debt to Equity Ratio and its meaning. Here we discuss the formula to calculate the Debt to Equity ratio along with practical examples, its uses, and interpretation and excel templates. You may also have a look at these articles below to learn more about Financial Analysis –
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