Debt Equity Ratio

What is the Debt Equity Ratio?

The debt equity ratio is the ratio of how much a business owes (debt) compared to how much the owners have invested (equity).

It is calculated by dividing debt by owners equity.

What is the Formula for the Debt Equity Ratio?

Debt Equity Ratio = Debt / Equity
  • Debt is given in the balance sheet and includes loans, overdrafts, hire purchase and any other borrowings. The bank may include leasing when calculating the ratio as they take a stricter approach.
  • Equity is found in the balance sheet and includes amounts invested by the owners and any retained profits.

How is the Debt Equity Ratio Calculated in Practice?

Example 1: Calculating the Debt to Equity Ratio
Cash 30,000
Accounts receivable 100,000
Inventory 20,000
Current assets 150,000
Long term assets 390,000
Total assets 540,000
Accounts payable 90,000
Other liabilities 40,000
Current liabilities 130,000
Long-term debt 210,000
Total liabilities 340,000
Capital 50,000
Retained earnings 150,000
Total equity 200,000
Total liabilities and equity 540,000

In the above example the borrowings are long-term debt amounting to 210,000 and the equity is 200,000. The debt to equity ratio is given by using the formula as follows:

Debt to equity ratio = Debt / Equity
Debt to equity ratio = 210,000 / 200,000
Debt to equity ratio = 1.05

Consider now what happens when the amount of equity is reduced.

Example 2: Highly Debt Equity Ratio Business
Cash 30,000
Accounts receivable 100,000
Inventory 20,000
Current assets 150,000
Long term assets 220,000
Total assets 370,000
Accounts payable 90,000
Other liabilities 40,000
Current liabilities 130,000
Long-term debt 180,000
Total liabilities 310,000
Capital 10,000
Retained earnings 50,000
Total equity 60,000
Total liabilities and equity 370,000

In Example 2 above, debt is 180,000 and equity 60,000. Using the formula, the debt to equity ratio is given as follows:

Debt equity ratio = Debt / Equity
Debt equity ratio = 180,000 / 60,000
Debt equity ratio = 3.00

In this case the total equity is reduced and the debt equity ratio has increased to 3. Note that the equity can be reduced by a reduction in retained earnings caused by losses within the business.

What does the Debt to Equity Ratio show?

A bank would not normally want to lend more than the owners of a business so from their point of view the maximum debt equity ratio is 1. Example 1 above shows approximately a 1:1 debt equity situation. In Example 2 above, the balance sheet gives an unacceptable debt to equity ratio of 3. The business is said to be highly geared or under capitalized, and a bank would view the business as having too much debt to allow it to borrow further funds.

Useful tips for using the Debt Equity Ratio

  • A bank will be reasonable happy with a debt equity ratio of 1 but will normally look for it to be in the region of 0.5 – 0.6.
  • A higher debt to equity ratio means higher risk.
  • Typically the debt to equity ratio will be 1, that is debt:equity of 1:1, but it varies from industry to industry.
  • A highly geared business is more risky but will give greater returns to the owners provided cash and profit are managed correctly.

Debt Equity Ratio and Debt Ratio

The debt or gearing ratio is the ratio of the debt to the assets of the business. The two terms are linked by the following formulas.

DER = DR / (1 – DR)
Variables used in the debt equity ratio formula
DER = Debt equity ratio = Debt / Equity
DR = Debt or gearing ratio = Debt / Assets = Debt / (Debt + Equity)

and

DR = DER / (1 + DER)
Variables used in the debt ratio formula
DER = Debt equity ratio = Debt / Equity
DR = Debt or gearing ratio = Debt / Assets = Debt / (Debt + Equity)

So for example, if the debt equity ratio is given as 1.50, then the debt ratio is calculated as follows:

DR = DER / (1 + DER)
DR = 1.50 / (1 + 1.50)
DR = 0.60
Debt Equity Ratio November 6th, 2016Team

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