Debt-to-equity ratio


Debt-to-equity ratio

The debt-to-equity ratio (D/E) is a financial ratio indicating the relative proportion of shareholders' equity and debt used to finance a company's assets.[1] Closely related to leveraging, the ratio is also known as Risk, Gearing or Leverage. The two components are often taken from the firm's balance sheet or statement of financial position (so-called book value), but the ratio may also be calculated using market values for both, if the company's debt and equity are publicly traded, or using a combination of book value for debt and market value for equity financially.

Contents

Usage

Preferred shares can be considered part of debt or equity. Attributing preferred shares to one or the other is partially a subjective decision but will also take into account the specific features of the preferred shares.

When used to calculate a company's financial leverage, the debt usually includes only the Long Term Debt (LTD). Quoted ratios can even exclude the current portion of the LTD. The composition of equity and debt and its influence on the value of the firm is much debated and also described in the Modigliani-Miller theorem.

Financial analysts and stock market quotes will generally not include other types of liabilities, such as accounts payable, although some will make adjustments to include or exclude certain items from the formal financial statements. Adjustments are sometimes also made to, for example, exclude intangible assets, and this will affect the formal equity; debt to equity (dequity) will therefore also be affected.

Financial economists and academic papers will usually refer to all liabilities as debt, and the statement that equity plus liabilities equals assets is therefore an accounting identity (it is, by definition, true). Other definitions of debt to equity may not respect this accounting identity, and should be carefully compared.

Formula

D/E = Debt(liabilities)/equity

(Sometimes only interest-bearing long-term debt is used instead of total liabilities in the calculation)

A similar ratio is debt-to-capital (D/C), where capital is the sum of debt and equity:

D/C = total liabilities / total capital = debt / (debt + equity)

The relationship between D/E and D/C is:

D/C = D/(D+E) = D/E / (1 + D/E)

The debt-to-total assets (D/A) is defined as

D/A = total liabilities / total assets = debt / (debt + equity + non-financial liabilities)

It is a problematic measure of leverage, because an increase in non-financial liabilities reduces this ratio.[2] Nevertheless, it is in common use.

In the financial industry (particularly banking), a similar concept is equity to total assets (or equity to risk-weighted assets), otherwise known as capital adequacy.

Background

On a balance sheet, the formal definition is that debt (liabilities) plus equity equals assets, or any equivalent reformulation. Both the formulas below are therefore identical:

A = D + E
E = A – D or D = A – E.

Debt to equity can also be reformulated in terms of assets or debt:

D/E = D /(A – D) = (A – E) / E.

Example

General Electric Co. ([1])

  • Debt / equity: 4.304 (total debt / stockholder equity) (340/79). Note: This is often presented in percentage form, for instance 430.4.
  • Other equity / shareholder equity: 7.177 (568,303,000/79,180,000)
  • Equity ratio: 12% (shareholder equity / all equity) (79,180,000/647,483,000)

See also

References

  1. ^ Peterson, Pamela (1999). Analysis of Financial Statements. New York: Wiley. p. 92. ISBN 1883249597. 
  2. ^ Welch, Ivo. A Bad Measure of Leverage: The Financial-Debt-To-Asset Ratio. SSRN. SSRN 931675. 

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