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.
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
Debt-Equity ratio = Long term
loans / Total long term funds
where long-term funds =
Long-term loans + Equity
From the following calculate the Debt-equity
|10,000 Equity shares @
|Sundry trade creditors
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.
Debentures + Sundry trade
creditors + Outstanding expenses / Equity capital + General reserve +
= 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.
= 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.