Debt-equity ratio analysis is one of several debt ratio analyses. Debt ratios measure the degree or financial leverage of the firm. The more debt the firm uses, the higher its financial leverage, the higher its financial risk (the risk of bankruptcy) and the higher the potential returns.
It measures the degree of indebtedness of the enterprise. It measures how much of equity and how much of debt a company uses to finance its assets. It is also referred to as leverage or gearing.
The formula is as follows:
Debt-equity ratio = Total liabilities/Shareholders equity
This formula is sometimes presented simply as:
Debt-equity ratio = Debt/Equity
Example of a debt-equity ratio analysis
Assume Gold Co. currently has total debt of $1,000,000 and shareholders equity of $1,800,000. The debt-equity ratio for the Gold Company is conducted as follows:
The result is less than 1 and indicates that business uses mainly equity to finance its operations. The financial risk of Gold Company seems to be under control. However, it is possible that company may have lower than possible returns due to being too careful with using debt financing. However, a closer investigation is required before any conclusions can be made.
Things to note about this ratio
If the debt-equity ratio shows a result of less than one, then it means that equity is mainly used to finance operations. However, if the debt-equity ratio is more than one, then it means that the debt is mainly used for financing of operations. If the result of debt-equity ratio analysis is equal to one, then it means that a half of financing comes from debt and a half comes from equity.
The more debt compared to equity the firm uses in financing its assets, the higher the financial risk and the higher the potential return. Financial risk refers to the risk of the firm being forced into bankruptcy if the firm does not meet its debt obligations as they come due.
The results should be compared to industry averages, to the firm’s past ratio trends and to a similar analysis of leading competitors within the industry.
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