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Debt-Equity Ratio:

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Definition:

The relationship between borrowed funds and internal owner's funds is measured by Debt-Equity ratio. This ratio is also known as debt to net worth ratio.

Formula:

The following formulas are used to calculate debt equity ratio:

  • Debt Equity Ratio = Total long term debts / shareholder' funds

Where total long-term debts excludes current liabilities. Shareholder's funds include (i) Ordinary share capital, (ii) Credit balance of profit and loss account and free reserves etc., but deduction should be made for fictitious assets if any in the balance sheet.

Shareholders funds or net worth = Owner's equity - Fictitious assets

Debt-equity ratio with above concept is also known as Debt to Net worth ratio.

  • Another version of Debt-Equity ratio (known as external-internal equity ratio) is where relationship is established between borrowed funds and owner's equity.

Debt-equity ratio = External equity ratio / Internal Equity ratio or Total debs / Shareholders equity

Where Total debts = (Short-term debts + Long-term debts).

The difference between this and the first approach is m respect of current liabilities. In the first approach current liabilities are excluded where as in the second approach the same are included.

  • Still another version of Debt-Equity ratio known as debts vs. funds ratio is when long-term loans are related to total long-term funds.

Debt-Equity ratio = Long term loans  / Total long term funds

where long-term funds = Long-term loans + Equity
 

Examples:

From the following calculate the Debt-equity ratio.

  $
10,000 Equity shares @ $10 each. 1,00,000
General reserve 45,000
Accumulated profit 30,000
Debentures 75,000
Sundry trade creditors 40,000
Outstanding expenses 10,000

Solution:

  • Debt-Equity Ratio = Total long term debts / Shareholders funds = 75,000 / 1,00,000 + 45,000 + 30,000 = 3 : 7

Every three dollars of long-term debts are being backed by an investment of  seven dollars by the owners. Thus the safety margin for creditors is more than double.
 

  • Debt-Equity ratio = External equity / Internal equity

 Debentures + Sundry trade creditors + Outstanding expenses / Equity capital + General reserve + Accumulated profits

= 75,000 + 40,000 + 10,000 / 1,00,000 + 45,000 + 30,000

= 1,25,000 / 1,75,000

= 5 : 7

Outsider's investment of $5 is matched well by owner's investment of $7.
 

  • Debt-Equity ratio = Total long term loans / Total long  term funds

= Debenture / Equity capital + Gen. reserve + Profits + Debentures

= 75,000 / 1,00,000 + 45,000 + 30,000 + 75,000

= 75,000 / 2,50,000

= 3 : 10

Every ten dollars of long-term funds include seven dollars of owners and three dollars of the outsiders.

Note: Because of different versions of this ratio it is advised that the student should state in his solution as to which version he has made use of.

More study material from this to
 

More study material from this topic:

Meanings, Nature and Usefulness of Ratios Analysis
Interpretation of Ratios
Important Factors for Understanding Ratios Analysis
Significance and Usefulness Ratios Analysis
Classification of Ratios
Analysis of Short Term Financial Position or Test of Liquidity
Current Ratio
Quick/Acid Test/Liquid Ratio
Absolute Liquid Ratio
Inventory/Stock Turnover Ratio
Debtors / Receivable Turnover Ratio
Creditors / Payables Turnover Ratio
Working Capital Turnover Ratio
Profitability Ratios
Gross Profit Ratio (GP Ratio)
Operating Profit Ratio
Net profit ratio (NP ratio)
Earnings Per Share Ratio
Operating ratio
Expense ratio
Solvency ratios - Test of Long Term Solvency
Debt-equity Ratio
Debt Service Ratio or Interest Coverage Ratio
Fixed Assets Ratio
Debts to Total Funds or Solvency Ratio
Reserves to Capital Ratio
Capital Gearing Ratio
Proprietary Ratio
Accounting Ratios Formulas
Limitations of Ratios Analysis

 

A D V E R T I S E M E N T

 

Financial Accounting Topics


  Introduction to Accounting
 ----------------------------------------------------------------------------
  Transactions and Accounting Equation
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  Analysis of Business Transactions
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  Journal, Ledger and Trial Balance
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  Accounting for Bills of Exchange
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  Special Journals
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  Cash Book
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Bank Reconciliation Statement
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  Final Accounts
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  Work Sheet
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  Capital and Revenue Items
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  Valuation of Inventories
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  Accounts of Non-profit Making Organizations
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  Statement of Cash Flows
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  Accounting Ratios Analysis
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  Depreciation, Provisions and Reserves
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  Accounting Dictionary
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  Financial Calculators
 
 
 
Managerial Accounting Topics

  Financial Statements
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  Cost Volume Profit Relationship
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  Variable Costing System
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  Materials and Inventory Cost Control
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  Activity Based Costing System
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  Standard Costing and Variance Analysis
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  Balanced Scorecard
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  Capital Investment Analysis/Capital Budgeting
 

 

 

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