Definition
The debt to equity ratio is an indicator of the leverage used by a company. The debt to equity ratio is considered a more stringent measure than the related debt ratio, since this metric tells the analyst how much debt is used to finance the company's assets relative to equity.
Calculation
Debt to Equity = Total Liabilities / Owner's Equity
Explanation
Companies need money to fuel their growth. If these new capital investments continue to provide additional profits to the business, then making interest payments to creditors is not problematic. If the company's business suddenly contracts, or the new capital investments do not provide the expected profits, then the company may struggle to make payments to creditors.
The debt to equity ratio relies on knowledge of the balance sheet equation: Assets = Liabilities + Owner's Equity. By examining the amount of debt (liabilities) relative to common stock (equity), the investor can determine the risk associated with this business. A lower debt to equity ratio indicates a safer investment to potential owners of the company.
Debt to equity ratios can vary by industry. When drawing conclusions about the relative performance of a company, benchmark comparisons should be made with competitors in the same industry.
Example
Company A's balance sheet indicates total liabilities of $16,196,000 and shareholder's equity of $15,420,000. Using the above formula, the debt to equity ratio would be:
= $16,196,000 / $15,420,000, or 1.05
Related Terms
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The financial accounting term liability is used to describe the debt of a corporation that results from a transaction involving the transfer of an asset or the provision of a service. Liabilities are reported on a company's balance sheet.
Moneyzine EditorNovember 6th, 2024- The financial accounting term owner's equity is used to describe the resources that are owned by the common and preferred stock shareholders of a company. Owner's equity is reported on a company's balance sheet.Moneyzine EditorNovember 6th, 2024
The financial term leverage refers to the use of debt to increase the total profits returned to the company's equity holders.Moneyzine EditorNovember 6th, 2024
The term leverage ratio is used to describe several measures of a company's financial leverage. Also known as gearing, leverage measures the amount of debt a company has issued relative to other capital such as equity.Moneyzine EditorNovember 6th, 2024- The debt ratio is a simple indicator of the leverage used by a company. The debt ratio measures the proportion of the total assets that are financed by debt, and not by stockholders.Moneyzine EditorNovember 6th, 2024
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