Debt to equity ratio

Debt to equity ratio

Debt to equity ratio (also termed as debt-equity ratio) is a long-term solvency ratio that indicates the soundness of the long-term financial policies of a company. It shows the relation between the portion of assets financed by creditors and the portion of assets financed by stockholders. As the debt to equity ratio expresses the relationship between external equity (liabilities) and internal equity (stockholder’s equity), it is also known as the “external-internal equity ratio”.

The debt to equity ratio is calculated by dividing total liabilities by the stockholder’s equity.

The numerator consists of the total of current and long-term liabilities and the denominator consists of the total stockholders’ equity including preferred stock. Both the elements of the formula are obtained from the company’s balance sheet.

Significance and interpretation:

A ratio of 1 (or 1: 1) means that creditors and stockholders equally contribute to the assets of the business.

A less than 1 ratio indicates that the portion of assets provided by stockholders is greater than the portion of assets provided by creditors and a greater than 1 ratio indicates that the portion of assets provided by creditors is greater than the portion of assets provided by stockholders.

Creditors usually like a low debt-to-equity ratio because a low ratio (less than 1) is an indication of greater protection for their money. But stockholders like to get benefits from the funds provided by the creditors therefore they would like a high debt to equity ratio.

Debt equity ratios vary from industry to industry. Different norms have been developed for different industries. A ratio that is ideal for one industry may be worrisome for another industry. A ratio of 1: 1 is normally considered satisfactory for most of the companies.