Learning Outcomes
- Calculate the debt to equity ratio
The debt-to-equity (D/E) ratio is calculated by dividing a company’s total liabilities by its shareholder equity:
[latex]\left(\dfrac{\text{company’s total liabilities}}{\text{shareholder equity}}\right)[/latex]
These numbers are available on the balance sheet of a company’s financial statements.
The ratio is used to evaluate a company’s financial leverage. The D/E ratio is an important metric used in corporate finance. It is a measure of the degree to which a company is financing its operations through debt versus wholly-owned funds. More specifically, it reflects the ability of shareholder equity to cover all outstanding debts in the event of a business downturn.
Assets are acquired either by investments from stockholders or through borrowing from other parties. Companies that are averse to debt would prefer a lower ratio. Companies that prefer to use “other people’s money” to finance assets would favor a higher ratio.
In the Jonick example, debt is 1.275 million and equity is 2.675 million.
[latex]\dfrac{1.275\text{ million}}{2.675\text{ million}}=.47663551\approx0.5[/latex]
This gives us a ratio of debt to equity of .47663551, or rounded to the nearest tenth, about 0.5, which could be stated as either 50% or ½.
| 2019 | |
|---|---|
| Liabilities | |
| Subcategory, Current liabilities: | |
| Accounts payable | $120,000 |
| Salaries payable | 244,000 |
| Total current liabilities | Single Line$364,000 |
| Subcategory, Long-term liabilities | |
| Mortgage note payable | $83,000 |
| Bonds payable | 828,000 |
| Total long-term liabilities | Single Line$911,000 |
| Total liabilities | Single Line$1,275,000Double Line |
| Stockholders’ Equity | |
| Preferred $1.50 stock, $20 par | $166,000 |
| Common stock, $10 par | 83,000 |
| Retained earnings | 2,426,000 |
| Total stockholders’ equity | $2,675,000 |
| Total liabilities and stockholders’ equity | Single Line$3,950,000Double Line |
If a company prefers to use borrowed money (leverage) to finance its operations, it would not be alarmed at a 1:1 ratio, or maybe even 2:1 ($2 of borrowed funds for every $1 of owner contributed capital, including retained earnings). Jonick has a ratio of 0.5:1, which could also be stated more clearly as 1:2, which means the company has only $1 of debt for every $2 of owner investment. Looking at this from a total asset standpoint, it means that for every $3 in total assets, $1 is debt financed and $2 is owner financed.
If you think of this in terms of a home purchase of say $300,000, it would mean that you have invested $200,000 of your own money and borrowed $100,000 from the bank. A ratio of 5:1, on the other hand, would mean that the homeowner had borrowed $250,000 and put $50,000 of her own money into the purchase.
So, if as an investor or business owner, you prefer to leverage (use the bank’s money to fund) your business, you would be looking at higher debt to equity ratios. If you prefer not to borrow, like Jonick, you would be expecting lower D/E indicators.
Now let’s practice what you’ve learned.
PRACTICE QUESTION
