Ratios: Debt to Equity Ratio - Online Tutor, Practice Problems & Exam Prep

The debt to equity ratio is a key leverage ratio that helps analyze how a company's assets are financed, comparing total liabilities to total equity. A ratio above 1.0 indicates that a company relies more on debt than equity, suggesting higher risk due to fixed interest payments. Understanding this ratio is crucial for assessing a company's financial health and risk profile, as it reflects the balance between debt and shareholder equity in financing operations.

Ratios: Debt to Equity Ratio

So here we go with another ratio, the debt to equity ratio. The debt to equity ratio is going to help us analyze how a company's assets are financed. Debt to equity ratio is a common leverage ratio. Leverage ratios deal with the amount of debt that we have. Leverage is always talking about debt. A highly levered company has a lot of debt. Cool? So remember that our fundamental equation assets equal liabilities plus equity. Well, assets are everything the company owns, and then this is how they're financed: the liabilities and the equity. Liabilities are what we owe to others, and equity is what's owned by the company, by the shareholders of the company.

Now, you may have learned about the debt ratio as well, right? I don't want you to confuse the debt to equity ratio with the debt ratio. The debt ratio compares total liabilities to total assets, right? So our numerator is total liabilities divided by total assets in our denominator. total liabilitiestotal assets. So that's our debt ratio. Notice this ratio, debt to equity as we have in our box here. Well, we've got our total liabilities divided by total equity in this case. total liabilitiestotal equity.

So, how do we analyze this? Remember that every ratio is going to tell us how much of the numerator for each one of the denominator. So, how many dollars of debt for each dollar of equity that we have. You can imagine that a debt to equity ratio above 1.0, anything above 1, is going to imply that the company relies more on debt than equity. Because how are we going to get a number bigger than 1? Well, that's if the numerator is bigger than the denominator. So, liabilities would have to be more than equity. Now when is this a little more of a red flag is when they have a very high ratio. That means that the company is highly levered. They're highly levered, they have a lot of leverage because they're going to depend more on the loans than the equity financing. So this implies that they're risky. It's a riskier company because they have a lot of loans. And why does that make them risky? Well, when you have a lot of loans, that means you're going to have a lot of interest payments. And those interest payments aren't going to go away. When you finance with equity, well, you pay dividends to the shareholders, but you don't necessarily have to pay those dividends. You can hold off on dividends, but interest expense, you're going to have to pay it. So that adds this fixed expense that you're definitely going to have to cover. If you can't cover it, well, you're going to be in trouble. Cool? So a high ratio implies more risk. Cool? Alright. This is a pretty easy ratio. Why don't we just jump into some practice problems right away? Let's do it now.

On its December 31 balance sheet, XYZ Company reported total assets of $880,000 and total liabilities of $560,000. What is the company's debt to equity ratio?

• A. .64
• B. .36
• C. .57
• D. 1.75

At the beginning of the year, ABC Company had total assets of $600,000, Total Liabilities of $360,000, and Total Equity of $240,000. At the end of the year, total assets had increased to $800,000, Total Liabilities decreased to $320,000 and Total Equity increased to $480,000. What was the change in the company's debt to equity ratio during the year?

• A. Increase by 0.83
• B. Increase by 0.20
• C. Decrease by 0.83
• D. Decrease by 0.20
• E. No change in the debt to equity ratio

Here’s what students ask on this topic:

What is the debt to equity ratio and why is it important?

The debt to equity ratio is a financial metric that compares a company's total liabilities to its total equity. It is calculated using the formula:

$\frac{\mathrm{Total} \mathrm{Liabilities}}{\mathrm{Total} \mathrm{Equity}}$

This ratio is important because it helps assess how a company's assets are financed, indicating the balance between debt and equity. A higher ratio suggests that a company relies more on debt, which can imply higher financial risk due to fixed interest payments. Understanding this ratio is crucial for evaluating a company's financial health and risk profile.

How do you calculate the debt to equity ratio?

To calculate the debt to equity ratio, you divide a company's total liabilities by its total equity. The formula is:

$\frac{\mathrm{Total} \mathrm{Liabilities}}{\mathrm{Total} \mathrm{Equity}}$

For example, if a company has $500,000 in total liabilities and $250,000 in total equity, the debt to equity ratio would be:

$\frac{500000}{250000}=2$

This means the company has $2 of debt for every $1 of equity.

What does a high debt to equity ratio indicate about a company?

A high debt to equity ratio indicates that a company relies more on debt than equity to finance its assets. This suggests that the company is highly leveraged, which can be risky. High leverage means the company has significant fixed interest payments, which must be met regardless of its financial performance. This increases financial risk, as failure to meet these obligations can lead to financial distress or bankruptcy. Therefore, a high debt to equity ratio often signals higher financial risk and potential instability.

How does the debt to equity ratio differ from the debt ratio?

The debt to equity ratio and the debt ratio are both leverage ratios, but they measure different aspects of a company's financial structure. The debt to equity ratio compares total liabilities to total equity, using the formula:

$\frac{\mathrm{Total} \mathrm{Liabilities}}{\mathrm{Total} \mathrm{Equity}}$

In contrast, the debt ratio compares total liabilities to total assets, using the formula:

$\frac{\mathrm{Total} \mathrm{Liabilities}}{\mathrm{Total} \mathrm{Assets}}$

While the debt to equity ratio focuses on the balance between debt and equity, the debt ratio provides insight into the proportion of a company's assets that are financed by debt.

What are the implications of a debt to equity ratio below 1.0?

A debt to equity ratio below 1.0 indicates that a company has more equity than debt. This suggests a lower level of financial leverage and, consequently, lower financial risk. Companies with a low debt to equity ratio are generally considered more financially stable, as they rely less on borrowed funds and have fewer fixed interest obligations. This can be advantageous during economic downturns, as the company is less burdened by debt repayments. However, it may also indicate that the company is not fully utilizing the potential benefits of leverage to grow its operations.