The debt equity ratio is the ratio of how much a business owes (debt) compared to how much the owners have invested (equity). Consequently a high D/E ratio indicates that a business is relying heavily on debt to finance its operations and growth, whereas a low D/E ratio indicates that the business is primarily relying on equity financing.
Debt Equity Ratio Formula
The debt equity ratio is calculated by dividing debt by owners equity, as shown in the following formula.
As can be seen the formula uses the following terms
- Firstly 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.
- Secondly equity is found in the balance sheet and includes amounts invested by the owners and any retained profits.
Debt Equity Calculation
| 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 |
As can be seen in the above example the borrowings are long-term debt amounting to 210,000 and the equity is 200,000. Accordingly the D/E ratio is given by using the formula as follows:
Debt to equity ratio = Debt / Equity Debt to equity ratio = 210,000 / 200,000 = 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 this case debt is 180,000 and equity 60,000. Consequently using the formula, the D/E ratio is given as follows:
Debt equity ratio = Debt / Equity Debt equity ratio = 180,000 / 60,000 = 3.00
In this case the total equity is reduced and the D/E ratio has increased to 3. Note that the equity can be reduced by a reduction in retained earnings caused by losses within the business.
A bank would not normally want to lend more than the owners of a business so from their point of view the maximum D/E ratio is 1. Example 1 above shows approximately a 1:1 debt equity situation. In contrast in Example 2 above, the balance sheet gives an unacceptable D/E ratio of 3. The business is said to be highly geared or undercapitalized, and a bank would view the business as having too much debt to allow it to borrow further funds.
Using the D/E Ratio
- A bank will be reasonable happy with a D/E ratio of 1 but will normally look for it to be in the region of 0.5 – 0.6.
- A higher D/E ratio means higher risk.
- Typically the D/E 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 vs Debt Ratio
The debt or gearing ratio is the ratio of the debt to the assets of the business. The two terms debt equity ratio (DER) and debt ratio (DR) are linked by the following formulas.
DER = DR / (1 - DR)
Variables used in the debt equity ratio formula
DER = Debt equity ratio = Debt / Equity
DR = Debt or gearing ratio = Debt / Assets = Debt / (Debt + Equity)
and
DR = DER / (1 + DER)
Variables used in the debt ratio formula
DER = Debt equity ratio = Debt / Equity
DR = Debt or gearing ratio = Debt / Assets = Debt / (Debt + Equity)
To illustrate if the DER is given as 1.50, then the DR is calculated as follows:
DR = DER / (1 + DER) DR = 1.50 / (1 + 1.50) = 0.60
Conclusion
A high D/E ratio can increase the financial risk of the business, as a significant portion of its earnings may need to be used to pay interest on its debt. Additionally, high levels of debt can make it more difficult for a business to obtain additional financing in the future, as lenders may be wary of the business’s ability to repay its debts.
In contrast a low D/E ratio may indicate that a business is financially stable, as it is not relying heavily on debt financing. However, this may also mean that the business is not taking advantage of the potential benefits of debt financing, such as tax deductions for interest payments.