FREE online courses on Financial Ratio Analysis - Leverage Ratios - Debt to
Equity
Debt to Equity is the ratio of Total Debt to Total Equity. It
compares the funds provided by creditors to the funds provided by shareholders.
As more debt is used, the Debt to Equity Ratio will increase. Since we incur
more fixed interest obligations with debt, risk increases. On the other hand,
the use of debt can help improve earnings since we get to deduct interest
expense on the tax return. So we want to balance the use of debt and equity such
that we maximize our profits, but at the same time manage our risk. The Debt to
Equity Ratio is calculated as follows:
Total Liabilities / Shareholders Equity
EXAMPLE - We have total liabilities of $ 75,000 and total
shareholders equity of $ 200,000. The Debt to Equity Ratio is 37.5%, $ 75,000 /
$ 200,000 = .375. When compared to our equity resources, 37.5% of our resources
are in the form of debt.
KEY POINT - As a general rule, it is advantageous to increase
our use of debt (trading on the equity) if earnings from borrowed funds exceeds
the costs of borrowing.
