## 3.2. Debt to equity ratio

Debt to equity ratio is often used to determine the ability of a company to repay its obligations. This ratio shows the company’s financial stability and dependence on creditors. The ratio is calculated by diving total liabilities by equity and is an alternative to the debt ratio.

Generally, companies with higher debt to equity ratios may be riskier because more of their assets are financed with debt. At the same time, companies with higher debt to equity ratios may provide a higher return on investment because such companies have access to more funds to expand their (profitable) operations.

Debt to Equity Ratio Formula

Debt to equity ratio is calculated by dividing total liabilities (current and non-current liabilities) by equity:

 Debt to Equity Ratio = Total Liabilities Shareholder’s Equity

Debt to Equity Ratio Example

As in our previous examples, let’s look at the financial statements of Friends Company and calculate the debt to equity ratio. The debt to equity ratio for fiscal year 20X9 can be determined as follows:

 Debt to Equity Ratio = \$5,300 + \$3,220 = 0.46 (rounded) \$18,350

Debt to equity ratio of 0.46 means that 46% of the company's assets are financed with debt and

54% (e.g., \$100% - 46%) are financed with shareholders' equity. Therefore, the company is considered to have a lower risk and has a strong equity position favorable to new creditors.

Important Notes

• Some advantages of the debt to equity ratio are easy calculation and sufficiency of results obtained. That’s why it is widely used for investment purposes. However, the debt to equity ratio can be distorted when a company has a substantial amount of operating liabilities in its total liabilities structure.
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