Debt Equity Ratio

What is the Debt Equity Ratio?

The Debt equity ratio is a financial calculation that indicates the relative proportion of a shareholder’s equity and debt used to finance a company’s assets. The ratio is closely related to leveraging and reveals the general risk associated with investing in the company or the organization’s long-term sustainability assuming that profits are kept in line.

The two components of the debt equity ratio are often taken from the corporation’s or company’s balance sheet or statement of financial position (also known as the company’s book value). That being said, the debt equity ratio may also be calculated by using the market values for both areas; this calculation is used if the company’s debt and equity are publicly traded and thus made available to the public. Additionally, a combination of book value for debt and market value for equity may be used to execute the debt equity ratio.

The Debt Equity Ratio Formula

The debt to equity ratio equals the company’s debts or liabilities divided by the assets under management. The debt equity ratio will be utilized in different ways and incorporate different forms of debts and assets; for example, sometimes only interest-bearing long-term debts are used as oppose to total liabilities in the calculation. That being said, the debt equity formula has been criticized because the increase in non-financial liabilities reduces the ratios yielding a problematic calculation. Nevertheless, the debt equity ratio is a common calculation used to evaluate the liquidity structure of a corporation.

Why is the Debt Equity Ratio Used?

The debt equity ratio is used as a fundamental calculation to reveal the liquidity of a corporation. Preferred shares can also be considered part of the debt equity ratio; when preferred shares are attributed to the calculation the ratio assumes more of a subjective feel.

When the debt equity ratio is used to calculate a company’s financial leverage, the debt typically includes on the Long Term Debt associated with the underlying business model. Quoted ratios may even eliminate the current portion of the company’s Long Term Debt schedule. The composition of equity and debt as it pertains to its subsequent influence on the value of the corporation or business model is generally debated and described in various financial theorems.

The debt equity ratio is used by investors and financial analysts to gauge the worthiness of a stock; it is a statistic used to evaluate the health of a corporation’s balance sheet. That being said, the majority of stock quotes will not include other forms of liabilities, including accounts payable, although some will make adjustments to incorporate or exclude items from the company’s detailed financial statements.

These adjustments are typically realized to exclude the presence of intangible assets that would otherwise affect the formal equity of the balance sheet. As a result of this exclusion, the debt equity ratio would also be affected.