Debt to equity ratio
The debt-to-equity ratio, which may also be referred to as the debt equity ratio, is a long term solvency ratio that reflects whether or not a company’s long-term financial strategies are healthy. It illustrates the relationship between the part of assets that are funded by creditors and the portion of assets that are financed by stockholders. Because it represents the link between external equity (liabilities) and internal equity (stockholder’s equity), the debt-to-equity ratio is sometimes referred to as the “external-internal equity ratio.” This is due to the fact that it measures the ratio of liabilities to stockholder’s equity.
Formula:
Total liabilities / Stockholder’s Equity
The sum of both short-term and long-term obligations make up the numerator, while the entire stockholders’ equity, including preferred stock, makes up the denominator. The balance statement of the corporation provides information for both of the components of the formula.
The significance and meaning of a ratio of 1 (sometimes written as 1: 1) is that it indicates that the contributions of shareholders and creditors to the assets of the company are equal.
If the ratio is less than one, it indicates that the portion of assets provided by stockholders is greater than the portion of assets provided by creditors. On the other hand, if the ratio is greater than one, it indicates that the portion of assets provided by creditors is greater than the portion of assets provided by stockholders.
Creditors often favour businesses with a low debt to equity ratio because a low ratio (one that is less than 1) indicates that their money is protected to a greater extent. However, shareholders want to reap benefits from the cash given by creditors, and as a result, they favour a debt to equity ratio that is quite high.
There is a wide range of debt equity ratios across different industries. Various business sectors have each evolved their own unique set of standards. It’s possible that a ratio that’s perfect for one business might be cause for concern in another. A ratio of one to one is often regarded to be adequate for the vast majority of businesses.