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Debt Equity Ratio

Definition

The debt-to-equity ratio is a financial ratio indicating the relative proportion of shareholders' equity and debt used to finance a company's assets. Closely related to leveraging, the ratio is also known as risk, gearing or leverage. The two components are often taken from the firm's balance sheet or statement of financial position, but the ratio may also be calculated using market values for both, if the company's debt and equity are publicly traded, or using a combination of book value for debt and market value for equity financially.

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Last Sourced: 2021-02-01
This Article has been Edited for Accessibility

Debt-to-equity ratio

The debt-to-equity ratio (D/E) is a financial ratio indicating the relative proportion of shareholders' equity and debt used to finance a company's assets. Closely related to leveraging, the ratio is also known as risk, gearing or leverage. The two components are often taken from the firm's balance sheet or statement of financial position (so-called book value), but the ratio may also be calculated using market values for both, if the company's debt and equity are publicly traded, or using a combination of book value for debt and market value for equity financially.

Usage

Preferred stock can be considered part of debt or equity. Attributing preferred shares to one or the other is partially a subjective decision but will also take into account the specific features of the preferred shares.

When used to calculate a company's financial leverage, the debt usually includes only the Long Term Debt (LTD). Quoted ratios can even exclude the current portion of the LTD. The composition of equity and debt and its influence on the value of the firm is much debated and also described in the Modigliani–Miller theorem.

Financial economists and academic papers will usually refer to all liabilities as debt, and the statement that equity plus liabilities equals assets is therefore an accounting identity (it is, by definition, true). Other definitions of debt to equity may not respect this accounting identity, and should be carefully compared. Generally speaking, a high ratio may indicate that the company is much resourced with (outside) borrowing as compared to funding from shareholders.

Formula

In a general sense, the ratio is simply debt divided by equity. However, what is classified as debt can differ depending on the interpretation used. Thus, the ratio can take on a number of forms including:

In a basic sense, Total Debt / Equity is a measure of all of a company's future obligations on the balance sheet relative to equity. However, the ratio can be more discerning as to what is actually a borrowing, as opposed to other types of obligations that might exist on the balance sheet under the liabilities section. For example, often only the liabilities accounts that are actually labelled as "debt" on the balance sheet are used in the numerator, instead of the broader category of "total liabilities". In other words, actual borrowings like bank loans and interest-bearing debt securities are used, as opposed to the broadly inclusive category of total liabilities which, in addition to debt-labelled accounts, can include accrual accounts like unearned revenue.

Another popular iteration of the ratio is the long-term-debt-to-equity ratio which uses only long-term debt in the numerator instead of total debt or total liabilities. Total debt includes both long-term debt and short-term debt which is made up of actual short-term debt that has actual short-term maturities and also the portion of long-term debt that has become short-term in the current period because it is now nearing maturity. This second classification of short-term debt is carved out of long-term debt and is reclassified as a current liability called current portion of long-term debt (or a similar name). The remaining long-term debt is used in the numerator of the long-term-debt-to-equity ratio.

A similar ratio is debt-to-capital (D/C), where capital is the sum of debt and equity:

The relationship between D/E and D/C is:

The debt-to-total assets (D/A) is defined as

It is a problematic measure of leverage, because an increase in non-financial liabilities reduces this ratio. Nevertheless, it is in common use.

In the financial industry (particularly banking), a similar concept is equity to total assets (or equity to risk-weighted assets), otherwise known as capital adequacy.

Background

On a balance sheet, the formal definition is that debt (liabilities) plus equity equals assets, or any equivalent reformulation. Both the formulas below are therefore identical:

Debt to equity can also be reformulated in terms of assets or debt:

Example

General Electric Co. ( )


Further Reading


Do sales–price and debt–equity explain stock returns better than book–market and firm size?Do sales–price and debt–equity explain stock returns better than book–market and firm size?
www.tandfonline.com [PDF]
… or have a rela- tively high B/MV tend to have weaker economic and financial … 2. LC Bhandari, "Debt/Equity Ratio and Expected Cormnon Stock Returns: Empirical Evidence," The Journal of … Risk Factors in the Returns on Stocks and Bonds," Journal of Financial Economics, vol …

Taxation, portfolio choice, and debt-equity ratios: A general equilibrium modelTaxation, portfolio choice, and debt-equity ratios: A general equilibrium model
academic.oup.com [PDF]
… or have a rela- tively high B/MV tend to have weaker economic and financial … 2. LC Bhandari, "Debt/Equity Ratio and Expected Cormnon Stock Returns: Empirical Evidence," The Journal of … Risk Factors in the Returns on Stocks and Bonds," Journal of Financial Economics, vol …

Adjusting the debt-equity ratioAdjusting the debt-equity ratio
www.tandfonline.com [PDF]
… or have a rela- tively high B/MV tend to have weaker economic and financial … 2. LC Bhandari, "Debt/Equity Ratio and Expected Cormnon Stock Returns: Empirical Evidence," The Journal of … Risk Factors in the Returns on Stocks and Bonds," Journal of Financial Economics, vol …

Some aspects of the pure theory of corporate finance: bankruptcies and take-oversSome aspects of the pure theory of corporate finance: bankruptcies and take-overs
www.jstor.org [PDF]
… or have a rela- tively high B/MV tend to have weaker economic and financial … 2. LC Bhandari, "Debt/Equity Ratio and Expected Cormnon Stock Returns: Empirical Evidence," The Journal of … Risk Factors in the Returns on Stocks and Bonds," Journal of Financial Economics, vol …

Relationship between financial leverage and financial performance: Empirical evidence of listed sugar companies of PakistanRelationship between financial leverage and financial performance: Empirical evidence of listed sugar companies of Pakistan
www.journalofbusiness.org [PDF]
… or have a rela- tively high B/MV tend to have weaker economic and financial … 2. LC Bhandari, "Debt/Equity Ratio and Expected Cormnon Stock Returns: Empirical Evidence," The Journal of … Risk Factors in the Returns on Stocks and Bonds," Journal of Financial Economics, vol …

Financial markets and the financing choice of firms: Evidence from developing countriesFinancial markets and the financing choice of firms: Evidence from developing countries
www.sciencedirect.com [PDF]
… or have a rela- tively high B/MV tend to have weaker economic and financial … 2. LC Bhandari, "Debt/Equity Ratio and Expected Cormnon Stock Returns: Empirical Evidence," The Journal of … Risk Factors in the Returns on Stocks and Bonds," Journal of Financial Economics, vol …

The debt-equity ratio of firms and the effectiveness of interest rate policy: Analysis with a dynamic model of saving, investment, and growth in KoreaThe debt-equity ratio of firms and the effectiveness of interest rate policy: Analysis with a dynamic model of saving, investment, and growth in Korea
link.springer.com [PDF]
… or have a rela- tively high B/MV tend to have weaker economic and financial … 2. LC Bhandari, "Debt/Equity Ratio and Expected Cormnon Stock Returns: Empirical Evidence," The Journal of … Risk Factors in the Returns on Stocks and Bonds," Journal of Financial Economics, vol …

Agency problems and debt financing: leadership structure effectsAgency problems and debt financing: leadership structure effects
www.emerald.com [PDF]
… or have a rela- tively high B/MV tend to have weaker economic and financial … 2. LC Bhandari, "Debt/Equity Ratio and Expected Cormnon Stock Returns: Empirical Evidence," The Journal of … Risk Factors in the Returns on Stocks and Bonds," Journal of Financial Economics, vol …



Q&A About Debt Equity Ratio


What is a good result for stockholders as long as the company earns a rate of return on assets that is greater than what?

A good result for stockholders as long as the company earns a rate of return on assets that is greater than what

How do you calculate an equity ratio?

You can calculate an equity ratio using market values or book values.

How do you calculate the DE?

You can calculate it by dividing total liabilities by total shareholder's equity.

What does the DE represent?

The DE represents how much leverage a firm has, or how much of its capital structure is financed with borrowed money. It also indicates how well secured creditors are in case of bankruptcy.

Why would you use market values instead of book values when calculating the DE?

Market value will give you a better idea about where things stand at present, but book value may be more accurate for historical comparisons over time.

What is the debt equity ratio?

The debt-to-equity ratio (DE) is a financial ratio indicating the relative proportion of shareholders' equity and debt used to finance a company's assets.

Where would you find information about this financial statement in most countries?

You will find information about this financial statement in most countries in their balance sheets.

What does the equity ratio measure?

The equity ratio measures the proportion of total assets that are financed by stockholders.

Is there more than one way to calculate the DE?

Yes, there are different ways to calculate it depending on your definition of what constitutes "debt".

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