Debt to Equity Ratio

Debt to equity ratio, also known as the debt-equity ratio, is a type of leverage ratio that is used to determine the financial leverage that a company uses. Debt to equity ratio takes into account the company’s liabilities and the shareholders equity.

It is regarded as an important ratio in accounting as it establishes a relationship between the total liabilities and shareholders equity of a company.

In other words, debt to equity ratio calculates to what extent the company is utilising debt as compared to equity for running the business.

A very significant part of the debt to equity ratio is that it depicts the ability of the shareholder’s equity to clear all the outstanding debts in case of the business going bankrupt.

Debt to equity ratio is an ideal ratio to judge a company’s financial performance. It can also help in checking the ability of the company in repaying its obligations.

Increase in the levels of debt to equity ratio indicates that the company is running on a debt fund, which can be risky in the long term.

Companies that have a higher debt to equity ratio find it difficult to obtain additional funding from other sources.

High debt to equity ratio presents a financial risk for companies. It means the company is using more debt as compared to equity for financing.

A low debt to equity ratio shows that a company has sufficient funds in the form of equity and there is no need for the company to obtain debt for financing the business.

Calculating Debt to Equity Ratio

Debt to equity ratio can be calculated by dividing the total liabilities by the total equity of the business.

It can be represented in the form of a formula in the following way

Debt to Equity Ratio = Total Liabilities / Shareholders Equity

Where,

Total liabilities = Short term debt + Long term debt + Payment obligations

Shareholders equity = Financing done by shareholders of the company

Let us understand the working of debt to equity ratio with a solved example.

Solved Example

Q. TBD Company has the following information available

Short term debt or liabilities – 5000

Long Term liabilities – 7000

Shareholder’s equity – 20000

Find the debt to equity ratio.

Answer:

We know that,

Debt to Equity Ratio = Total Liabilities / Shareholders Equity

And,

Total Liabilities = Short term debt + Long term debt + Payment obligations

= 5000 +7000

=12,000

Shareholder’s equity = 20,000

Now,

Debt to Equity Ratio = 12000 / 20000

= 0.6

This means that debts consist of 60% of shareholder’s equity.

This concludes our article on the topic of Debt to Equity Ratio, which is an important topic in Class 12 Accountancy for Commerce students. For more such interesting articles, stay tuned to BYJU’S.

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