Home page     Downloads      Privacy policy     Disclaimer & terms of use     Contact us     Advertise with us     About us      Link to us

Home » Financial Statement Analysis » Debt to Equity Ratio

# Debt to Equity Ratio:

## Definition:

Debt-to-Equity ratio indicates the relationship between the external equities or outsiders funds and the internal equities or shareholders funds.

It is also known as external internal equity ratio. It is determined to ascertain soundness of the long term financial policies of the company.

## Formula of Debt to Equity Ratio:

Following formula is used to calculate debt to equity ratio

[Debt Equity Ratio = External Equities / Internal Equities]

Or

[Outsiders funds / Shareholders funds]

As a long term financial ratio it may be calculated as follows:

[Total Long Term Debts / Total Long Term Funds]

Or

[Total Long Term Debts / Shareholders Funds]

## Components:

The two basic components of debt to equity ratio are outsiders funds i.e. external equities and share holders funds, i.e., internal equities. The outsiders funds include all debts / liabilities to outsiders, whether long term or short term or whether in the form of debentures, bonds, mortgages or bills. The shareholders funds consist of equity share capital, preference share capital, capital reserves, revenue reserves, and reserves representing accumulated profits and surpluses like reserves for contingencies, sinking funds, etc. The accumulated losses and deferred expenses, if any, should be deducted from the total to find out shareholder's funds

Some writers are of the view that current liabilities do not reflect long term commitments and they should be excluded from outsider's funds. There are some other writers who suggest that current liabilities should also be included in the outsider's funds to calculate debt equity ratio for the reason that like long term borrowings, current liabilities also represents firm's obligations to outsiders and they are an important determinant of risk. However, we advise that to calculate debt equity ratio current liabilities should be included in outsider's funds. The ratio calculated on the basis outsider's funds excluding liabilities may be termed as ratio of long-term debt to share holders funds.

## Example:

From the following figures calculate debt to equity ratio:

 Equity share capital Capital reserve Profit and loss account 6% debentures Sundry creditors Bills payable Provision for taxation Outstanding creditors 1,100,000 500,000 200,000 500,000 240,000 120,000 180,000 160,000

Required: Calculate debt to equity ratio.

### Calculation:

External Equities / Internal Equities

= 1,200,000 / 18,000,000

= 0.66 or 4 : 6

It means that for every four dollars worth of the creditors investment the shareholders have invested six dollars. That is external debts are equal to 0.66% of shareholders funds.

## Significance of Debt to Equity Ratio:

Debt to equity ratio indicates the proportionate claims of owners and the outsiders against the firms assets. The purpose is to get an idea of the cushion available to outsiders on the liquidation of the firm. However, the interpretation of the ratio depends upon the financial and business policy of the company. The owners want to do the business with maximum of outsider's funds in order to take lesser risk of their investment and to increase their earnings (per share) by paying a lower fixed rate of interest to outsiders. The outsiders creditors) on the other hand, want that shareholders (owners) should invest and risk their share of proportionate investments. A ratio of 1:1 is usually considered to be satisfactory ratio although there cannot be rule of thumb or standard norm for all types of businesses. Theoretically if the owners interests are greater than that of creditors, the financial position is highly solvent. In analysis of the long-term financial position it enjoys the same importance as the current ratio in the analysis of the short-term financial position.

### You may also be interested in other articles from "financial statement analysis" chapter:

Managerial Accounting

 ■ Introduction to Managerial Accounting ■ Business and Quality Improvement Programs ■ Cost Terms, Concepts and Classification ■ Job Order Costing system ■ Process Costing System ■ Process Costing System - Addition of Materials & Beginning Inventory ■ Controlling and Costing Materials ■ Materials and Inventory Cost Control ■ By Products and Joint Products Costing ■ Cost-Volume-Profit-Relationship ■ Variable Costing System ■ Activity Based Costing System ■ Budgeting and Planning ■ Standard Costing and Variance Analysis ■ Gross Profit Analysis ■ Linear Programming Technique ■ Segment Reporting and Transfer Pricing ■ Capital Budgeting Decisions ■ Service Department Costing ■ Cash Flow statement ■ Financial statement Analysis ■ Pricing Products and Services ■ Managerial Accounting Terms and Definitions ■ Managerial / Cost Accounting Formulas

Financial Accounting

 ■ Bookkeeping and Bookkeeping Terms ■ Accounting Principles and Accounting Equation ■ Journal ■ Ledger ■ Accounting For Bills of Exchange ■ Subdivision of Journal ■ Final Accounts ■ Capital and Revenue Items ■ Single Entry System/Accounting From Incomplete Records ■ Accounting For Non-Trading Concerns ■ Accounting for Consignment / Consignment Accounts ■ Accounting for Joint Ventures ■ Accounting for Depreciation

About us !

 Also see formula of gross margin ratio method with financial analysis, balance sheet and income statement analysis tutorials for free download on Accounting4Management.com.Accounting students can take help from Video lectures, handouts, helping materials, assignments solution, Online Quizzes, GDB, Past Papers, books and Solved problems. Also learn latest Accounting & management software technology with tips and tricks.
 Home page   Download Material   Privacy policy   Disclaimer & terms of use   Contact us   Advertise with us   About us   Useful links   Link to us Copyrights of all content on this web site are owned by Accounting For Management except where indicated in source or copyright statements. Accounting For Management must be contacted for permission to copy or redistribute any material published on this website. Copyright 2014 Accounting For Management. All rights reserved.