Debt to equity ratio
Encyclopedia
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. 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.
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 economist
s 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.
(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:
The relationship between D/E and D/C is:
The debt-to-total assets (D/A) is defined as
It is a problematic measure of leverage, because an increase in non-financial liabilities reduces this ratio. 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.
, the formal definition is that debt (liabilities) plus equity equals assets, or any equivalent reformulation. Both the formulas below are therefore identical:
Debt to equity can also be reformulated in terms of assets or debt:
Financial ratio
A financial ratio is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization...
indicating the relative proportion of shareholders' equity and debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
used to finance a company's assets. Closely related to leveraging
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
, the ratio is also known as Risk, Gearing or Leverage. The two components are often taken from the firm's balance sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
or statement of financial position (so-called book value
Book value
In accounting, book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or Impairment costs made against the asset. Traditionally, a company's 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.
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
Modigliani-Miller theorem
The Modigliani–Miller theorem forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process , in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is...
.
Financial analysts and stock market quotes will generally not include other types of liabilities, such as accounts payable
Accounts payable
Accounts payable is a file or account sub-ledger that records amounts that a person or company owes to suppliers, but has not paid yet , sometimes referred as trade payables. When an invoice is received, it is added to the file, and then removed when it is paid...
, 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 economist
Economist
An economist is a professional in the social science discipline of economics. The individual may also study, develop, and apply theories and concepts from economics and write about economic policy...
s 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
Accounting identity
In finance and economics, an accounting identity is an equality that must be true regardless of the value of its variables, or a statement that by definition must be true. The term is also used in economics to refer to equalities that are by definition or construction true, such as the balance of...
(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. 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 sheetBalance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
, 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. (http://finance.yahoo.com/q/bs?s=GE&annual)- 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 ratioEquity ratioThe equity ratio is a financial ratio indicating the relative proportion of equity used to finance a company's assets. The two components are often taken from the firm's balance sheet or statement of financial position , but the ratio may also be calculated using market values for both, if the...
: 12% (shareholder equity / all equity) (79,180,000/647,483,000)