Debt To Equity Ratio Definition – Formula Example & Interpretation

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debt to equity ratio definition

Debt To Equity Ratio Definition & Example

Debt To Equity Ratio Definition – A comparison of a company’s outstanding loans to its owner’s equity. To calculate, divide total liabilities by owner’s equity.

In simple words, this ratio compares the company’s debts with the shareholder’s equity or owner’s equity. It shows the percentage of portion of debt that comes from creditors and investors. Higher Debt/Equity ratio indicates the creditors investment in the company is more than the investors investment. It’s a Balance Sheet ratio as all the items involved in calculation of this ratio appears in the Balance Sheet.

Formula

Debt To Equity Ratio = Total Liabilities/ Total Equity

Debt – Equity Ratio Example

Let’s discuss an example in order to understand the debt to equity ratio in a better way.

XYZ Ltd is a Plasma television manufacturing company. The bank loans are of Rs 10,00,000 and other liabilities amount to Rs. 3,00,000. Company has shareholder capital of Rs. 17,00,000.

Debt/ Equity  = (10,00,000 + 3,00,000)/17,00,000

= 0.7

Related Financial Terms of Debt/Equity

Interpretation of Debt/Equity Ratio

With companies to companies this ratio varies. Some goes more for debt financing and less for equity financing and vice versa. A debt – equity ratio equals to 1 means that both creditors and investors have a equal stake in the organisation.

Similarly if the debt to equity ratio is lower, it means that company has more equity financing. This situation is considered financially sound. As equity shareholders are to be paid at the time of liquidation of the company.

A higher Debt/Equity  implies that creditor financing in the company is comparatively high than equity financing. This situation is considered very risky. As a regular interest payment is made to the creditors. So, organisation always needs cash in hand in this circumstance. In addition to this, debt is more expensive than equity.

Creditors always look for companies having lower debt – equity ratio. Higher debt – equity ratio implies that the contribution of investors is very less. The reasons could be that organisation is not performing up to the mark. That’s why firm is looking for debt financing. In such cases, creditors also back out.

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