A company’s capital structure may comprise of equity and debt. Debt equity ratio is used to measure the proportion in which debt and equity has been used by the company to finance its assets. While deciding on the mode of obtaining/raising funds through equity or debt, a company has to consider the benefits and costs associated with each mode.

In case of debt, a company has to pay interest on the amount borrowed by it. In case of equity, a company may have to pay dividends to its shareholders out of the profits earned by the company. However, in case of equity, there is no fixed obligation on the part of the company to pay dividends; shareholders may expect a capital appreciation of their investments made in the company.

A high proportion of debt may indicate that the company has to pay a substantial amount of interest on the amount of total debt. Since, payment of interest is a fixed obligation for the company, a higher composition of debt in company’s capital structure may indicate higher risk in comparison to equity. Irrespective of the level of profits earned by the company, interest will have to be paid by the company on the amount of debt it holds in its balance sheet. A comparison of   financial leverage of companies within the same industry can be made with the help of debt equity ratio.

To calculate debt to equity ratio, we need to understand the components of debt and equity.

Components of Debt and Equity

Debt

Debt can further be segregated into long term debt and short term debt. A company’s balance sheet may include debentures, bonds, notes payables and so on. Different components of debt may be used by the analyst for calculating debt to equity ratio. For Instance, a particular analyst may include short term debt in the calculation of debt to equity ratio while another analyst may consider only term obligations of the company in the calculation of debt to equity ratio of the same company.

Equity

Shareholder’s equity generally comprises of share capital (equity and preference), reserves (capital and revenue), and any amount of accumulated reserves or profits. It is not necessary that a company has all these components as a part of its equity. For Instance, some companies may prefer to raise money only through issuance of common stock while other companies may also raise money through issuance of preference stock. It is important for the analyst to understand the objective behind the calculation of debt to equity ratio and select the components of debt and equity accordingly.

Also Read

The Fair Debt Collection Practices Act
How To Reduce Debt Using The Snowball Debt Reduction Method?
Understanding Return on Equity
Tips for Debt Investment
Equity Investment Made Easy

Calculation of Debt to Equity Ratio

Debt to equity ratio is frequently calculated by dividing debt by equity appearing in the balance sheet of the company and is represented by the following equation:

Debt to Equity Ratio = Debt/Shareholder’s Equity

Let us understand the calculation of Debt to Equity ratio with the help of an example.

ABC Company has following figures for equity and debt on the liabilities side of its balance sheet.

Shareholder’s Equity: $ 12, 000
Long Term Debt: $ 36, 000

On the basis of figures mentioned above, debt to equity ratio for the company would be 3 times (36, 000/12,000). A debt to equity ratio of 3 times indicates that company has used more of debt in financing its assets.