Debt to Equity Ratio

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.

Jonick Company
Comparative Balance Sheet
December 31, 2019 and 2018
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.