What is the Debt Equity Ratio?
The debt equity ratio is the ratio of how much a business owes (debt) compared to how much the owners have invested (equity).
It is calculated by dividing debt by owners equity.
What is the Formula for the Debt Equity Ratio?
- Debt is given in the balance sheet and includes loans, overdrafts, hire purchase and any other borrowings. The bank may include leasing when calculating the ratio as they take a stricter approach.
- Equity is found in the balance sheet and includes amounts invested by the owners and any retained profits.
How is the Debt Equity Ratio Calculated in Practice?
| Cash | 30,000 |
| Accounts receivable | 100,000 |
| Inventory | 20,000 |
| Current assets | 150,000 |
| Long term assets | 390,000 |
| Total assets | 540,000 |
| Accounts payable | 90,000 |
| Other liabilities | 40,000 |
| Current liabilities | 130,000 |
| Long-term debt | 210,000 |
| Total liabilities | 340,000 |
| Capital | 50,000 |
| Retained earnings | 150,000 |
| Total equity | 200,000 |
| Total liabilities and equity | 540,000 |
In the above example the borrowings are long-term debt amounting to 210,000 and the equity is 200,000. The debt to equity ratio is given by using the formula as follows:
Debt to equity ratio = Debt / Equity Debt to equity ratio = 210,000 / 200,000 Debt to equity ratio = 1.05
Consider now what happens when the amount of equity is reduced.
| Cash | 30,000 |
| Accounts receivable | 100,000 |
| Inventory | 20,000 |
| Current assets | 150,000 |
| Long term assets | 220,000 |
| Total assets | 370,000 |
| Accounts payable | 90,000 |
| Other liabilities | 40,000 |
| Current liabilities | 130,000 |
| Long-term debt | 180,000 |
| Total liabilities | 310,000 |
| Capital | 10,000 |
| Retained earnings | 50,000 |
| Total equity | 60,000 |
| Total liabilities and equity | 370,000 |
In Example 2 above, debt is 180,000 and equity 60,000. Using the formula, the debt to equity ratio is given as follows:
Debt equity ratio = Debt / Equity Debt equity ratio = 180,000 / 60,000 Debt equity ratio = 3.00
In this case the total equity is reduced and the debt equity ratio has increased to 3. Note that the equity can be reduced by a reduction in retained earnings caused by losses within the business.
What does the Debt to Equity Ratio show?
A bank would not normally want to lend more than the owners of a business so from their point of view the maximum debt equity ratio is 1. Example 1 above shows approximately a 1:1 debt equity situation. In Example 2 above, the balance sheet gives an unacceptable debt to equity ratio of 3. The business is said to be highly geared or under capitalized, and a bank would view the business as having too much debt to allow it to borrow further funds.
Useful tips for using the Debt Equity Ratio
- A bank will be reasonable happy with a debt equity ratio of 1 but will normally look for it to be in the region of 0.5 – 0.6.
- A higher debt to equity ratio means higher risk.
- Typically the debt to equity ratio will be 1, that is debt:equity of 1:1, but it varies from industry to industry.
- A highly geared business is more risky but will give greater returns to the owners provided cash and profit are managed correctly.
Debt Equity Ratio and Debt Ratio
The debt or gearing ratio is the ratio of the debt to the assets of the business. The two terms are linked by the following formulas.
DER = Debt equity ratio = Debt / Equity
DR = Debt or gearing ratio = Debt / Assets = Debt / (Debt + Equity)
and
DER = Debt equity ratio = Debt / Equity
DR = Debt or gearing ratio = Debt / Assets = Debt / (Debt + Equity)
So for example, if the debt equity ratio is given as 1.50, then the debt ratio is calculated as follows:
DR = DER / (1 + DER) DR = 1.50 / (1 + 1.50) DR = 0.60