Debt to Equity Ratio:

Definition:

Debt-to-Equity ratio indicates the relationship between the external equities or outsiders funds and the internal equities or shareholders funds.

It is also known as external internal equity ratio. It is determined to ascertain soundness of the long term financial policies of the company.

Formula of Debt to Equity Ratio:

Following formula is used to calculate debt to equity ratio

 [Debt Equity Ratio = External Equities / Internal Equities]

Or

[Outsiders funds / Shareholders funds]

As a long term financial ratio it may be calculated as follows:

[Total Long Term Debts / Total Long Term Funds]

Or

[Total Long Term Debts / Shareholders Funds]

Components:

The two basic components of debt to equity ratio are outsiders funds i.e. external equities and share holders funds, i.e., internal equities. The outsiders funds include all debts / liabilities to outsiders, whether long term or short term or whether in the form of debentures, bonds, mortgages or bills. The shareholders funds consist of equity share capital, preference share capital, capital reserves, revenue reserves, and reserves representing accumulated profits and surpluses like reserves for contingencies, sinking funds, etc. The accumulated losses and deferred expenses, if any, should be deducted from the total to find out shareholder's funds

Some writers are of the view that current liabilities do not reflect long term commitments and they should be excluded from outsider's funds. There are some other writers who suggest that current liabilities should also be included in the outsider's funds to calculate debt equity ratio for the reason that like long term borrowings, current liabilities also represents firm's obligations to outsiders and they are an important determinant of risk. However, we advise that to calculate debt equity ratio current liabilities should be included in outsider's funds. The ratio calculated on the basis outsider's funds excluding liabilities may be termed as ratio of long-term debt to share holders funds.

Example:

From the following figures calculate debt to equity ratio:

Required: Calculate debt to equity ratio.

Calculation:

External Equities / Internal Equities

= 1,200,000 / 18,000,000

= 0.66 or 4 : 6

It means that for every four dollars worth of the creditors investment the shareholders have invested six dollars. That is external debts are equal to 0.66% of shareholders funds.

Significance of Debt to Equity Ratio:

Debt to equity ratio indicates the proportionate claims of owners and the outsiders against the firms assets. The purpose is to get an idea of the cushion available to outsiders on the liquidation of the firm. However, the interpretation of the ratio depends upon the financial and business policy of the company. The owners want to do the business with maximum of outsider's funds in order to take lesser risk of their investment and to increase their earnings (per share) by paying a lower fixed rate of interest to outsiders. The outsiders creditors) on the other hand, want that shareholders (owners) should invest and risk their share of proportionate investments. A ratio of 1:1 is usually considered to be satisfactory ratio although there cannot be rule of thumb or standard norm for all types of businesses. Theoretically if the owners interests are greater than that of creditors, the financial position is highly solvent. In analysis of the long-term financial position it enjoys the same importance as the current ratio in the analysis of the short-term financial position.

 

You may also be interested in other relevant articles: Horizontal Analysis or Trend Analysis Trend Percentage Vertical Analysis Limitations of Financial Statement Analysis Accounting Ratios definition, advantages, classifications and limitations Financial Ratio Formulas Profitability ratios: Gross profit ratio Net profit ratio Operating ratio Expense ratio Return on shareholders investment or net worth Return on equity capital Return on capital employed (ROCE) ratio Dividend yield ratio Dividend payout ratio Earnings Per Share Ratio Price earning ratio Liquidity ratios: Current ratio Liquid /Acid test / Quick ratio Activity ratios: Inventory/Stock turnover ratio Debtors/Receivables turnover ratio Average collection period Creditors/Payable turnover ratio Working capital turnover ratio Fixed assets turnover ratio Over and under trading Leverage ratios or long term solvency ratios: Debt equity ratio Proprietary or Equity ratio Ratio of fixed assets to shareholders funds Ratio of current assets to shareholders funds Interest coverage or debt service ratio Capital gearing ratio Over and under capitalization

 

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