Investment Formula Description
Debt equity ratio is an investment formula to measure a corporation's financial leverage.
As its names, debt equity ratio is dividing it debts or total liabilities by shareholders' equity or net assets. Sometimes, debt equity ratio can use long-term debt ( LTD ) instead of total liabilities to calculate too. Besides, debt equity ratio or debt to equity ratio indicates the proportion of equity and debt the company is using to finance its assets.Corporations with high debt equity ratio are corporations that aggressively finance its growth with debt and the corporations are required to pay additional interest expenses. In normal case, corporations are encouraged to increase its debts if it found that the earnings of raising debts will be greater than the additional interest expenses. In this case, after paying off the interest, the remaining earnings will eventually return to shareholders. However, the corporations still need to estimate the risk of maintaining the earnings to prevent overuse of debts to finance its operations, which can lead to bankruptcy. As other financial ratio or investment formula, debt equity ratio or debt to equity ratio are useful to compare with corporations in same industry. Some capital-intensive industries are tend to have higher debt equity ratio. For instance, construction companies required more capital by raising debts while consulting firm does not need much capital to operate.
Investment Formula Example
If Corporation ABC has $ 2,200,000 total liabilities and $3,200,000 shareholders' equity, debt equity ratio calculation is as following.
Debt equity ratio or debt to equity ratio = total liabilities / shareholders' equity = 2,200,000 / 3,200,000 = 0.6875
Corporation ABC has 0.6875 of debt equity ratio. It means that corporation ABC does not raise much debts to operate its corporation.
If corporation IJK has $200,000 long term debts and $100,000 net assets, the debt equity ratio calculation is as following.
Debt equity ratio or debt to equity ratio = long term liabilities / net assets = 200,000 / 100,000 = 2
Corporation IJK has 2 of debt equity ratio. Hence, corporation IJK is raising 2 times of its shareholders' equity as debts to operate its business. Hence, corporation IJK is running in higher risk compared with corporation ABC and corporation IJK might have better earnings if it is able to earn more than the interest payable.