Debt to Equity Ratio Formula

Not everyone knows the complete essence and the ramifications of this formula. This is a simple financial debt ratio and it is used for determining the nature of the money that is used for financing the assets of a business organization. It is no secret that these finances come in the form of shareholders equity and other forms, and it is essential for a company to maintain a healthy balance of both amounts in order to function with efficiency and longevity.

These amounts are derived from the balance sheet of the firm, which happens to be one of the three financial statements that every company publishes and maintains at least once a year. This simple formula merely shows the proportion at which either of these sources are used in order to finance the assets and the operations of the firm.

An Example

The simple formula for this value is represented as follows.

Debt to Equity Ratio = Total Liabilities (long-term debt + short-term debt) / Shareholders' Equity

By getting a figure for this, the firm can determine what proportion of their total debt is made up of shareholders equity, and this information can prove valuable and priceless in the long run. Shareholders are people who own shares and stocks of the company, but ultimately they need to be paid interest (on an annual basis) and their share amount as well (when the term expires). If a company relies heavily on shareholders' equity, then they could be at a disadvantage. Thus they will need to figure out financial management and financial planning solutions to balance their liabilities properly, so that not too much of it is made up of shareholders' equity. This example will make this concept clearer.

Suppose a company's total debt is $15 million, and this consists of $10 million long-term debt and $5 million short-term debt. At the same time, the $10 million long-term debt is completely made up of shareholders' equity. So the formula tells us that this ratio is 15 / 10, or 150% or 1.5 times.

Long-Term Debt to Equity = Long-Term Debt / Shareholders' Equity

In this example, this value is equal to 10 / 10 or 100%. Once you learn how to calculate the ratio, it is important to understand its significance as well. A larger debt to equity ratio means that the company owes a lot of money to outsiders as well, in addition to shareholders. This can be beneficial and disruptive at the same time. Too much money owed to different parties raises the amount of interest to be paid. But on the other hand, too much dependence on shareholders increases the responsibility of the firm to pay these shareholders. Many companies would prefer to owe money to shareholders rather than external creditors, but this also comes with its own set of disadvantages.

To better understand the concept one should use the formula to compare a company's debt to equity ratio with its own, over a period of time. Different industries have different needs, so one should also compare it with companies working in the same industry. This gives the company an idea about its capital structure and its liability and asset management, and this information is priceless. Maintaining a healthy ratio is vital for the success and the functionality of any business organization.