Debt to Equity ratio is a debt ratio which measures the degree to which the assets of a business is being financed by obtaining debt and equity. or how much debt is being used by a company relative to the amount of equity for the financing of its assets?
Debt to Equity ratio = Total liabilities / Shareholders’ equity
Both values of total liabilities and shareholders’ equity can be taken from the balance sheet of a company.
Suppose, a company Z has a long-term loan of $1 million with a commercial bank, a short-term debt to finance its inventory of $0.5 million and total equity of $2.5 million. Using the formula for calculating debt to equity ratio and given information we can calculate the company Z debt ratio as under:
Debt to Equity ratio = Total liabilities / Shareholders’ equity = $1 + $0.5 / $2.5 = 0.6
Total liabilities comprise both long-term and short-term debt totaling $1.5 million.
The answer of the ratio is usually taken in times or a percentage like 0.6 times means that for every dollar of Company Z owned by the shareholders, Company Z owes $0.60 to creditors. Debt to equity ratio with less value is considered favorable due to a low level of debt whereas the ratio with high value is considered unfavorable as there is an increased amount of debt and an increased risk which means that the percentage of assets which are financed by debts is increasing.
Limitations of debt to equity ratio
- This ratio can only compare two companies within an industry because different industries have different debt levels like capital intensive industry require more debt as compare to a service-intensive industry.
- Total liabilities may be calculated in different ways for the formula like some analysts may consider preferred stock as debt rather than etc.