Wednesday, 25 January 2012

Debt to Equity Ratio

Debt to Equity Ratio Definition:
Debt to equity ratio defined as an indication of management’s reliance to finance its asset on debt rather than on equity. It measures a company’s capacity to repay its creditors. The debt to equity ratio varies with different industry and company. Comparing the ratio with industry peers is a better benchmark.

Debt to Equity Ratio Meaning:
The debt ratio means an indication of the gearing level of a company. A high ratio means that a company may be over-leveraged with debt. This can result in high insolvent risk since excessive debt can lead to a heavy debt repayment burden. However, when a company chooses to rely largely on equity, they may lose the tax reduction benefit of interest payments. In a word, a company must consider both risk and tax issues to get an optimal debt to equity ratio explanation that suits their needs.

Debt to Equity Ratio Formula:
The debt to equity ratio formula is listed below:

Debt to equity ratio equation = total debt / total equity

Debt to Equity Ratio Calculation:
Debt to equity ratio calculations are a matter of simple arithmetic once the propper information is complied. Debts will include both current liabilities and long term liabilities.

Equity will include goods and property your business owns, plus any claims it has against other entities.

Example: a company has $10,000 in total debt, and $40,000 in total shareholders equity.

Debt to equity ratio = 10,000 / 40,000 = 0.25

This means that a company has $0.25 in debt for every dollar of shareholders’ equity.

Debt to Equity Ratio Example:
Shari has started a residential real estate company which has grown to success. Though the market is tough, Shari has protected her cash account in order to deal with what the future holds. Shari now needs to perform debt to equity analysis to make sure she has not become over-leveraged in her company. This could cause problems with bank loans, her company free cash flow, and more.

Shari contacts her controller for debt to equity accounting questions. She knows that there is no debt to equity calculator, so she is willing to wait for some concrete results.

$10,000 in total debt and $40,000 in total shareholders equity.

Debt to equity ratio = $10,000 / $40,000 = $0.25

Her controller finds that she is in perfect standing. Her company, though near its limit, does not have too much debt. It has enough cash to survive common issues which face the residential real estate industry.

She is satisfied that she has followed the path of a responsible business owner. She is so used to putting out fires that she is content with the status quo of her company making regular monthly profits. Shari looks forward to her next quarter.


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