Debt to Equity Ratio

The debt to equity ratio is also termed as D/E ratio. It is basically a form of financial ratio that refers to the comparison between the percentage of debt and equity utilized for funding the assets of a company. It is calculated by dividing the entire amount of debt by the equity of the shareholders. The two constituents of debt to equity ratio are frequently picked up from the balance sheet of a company or its financial statements (supposed book value). However, the computation of debt to equity ratio can also be done applying market values for both elements, in case the equity and debt of the company have been traded publicly or implementing a collection of a market value for equity and book value for debt.

The preference shares are regarded as a component of equity or debt. Assigning preference shares to debt or equity is in part an immanent decision, however, it also takes into consideration the particular characteristics of the preference stocks.

At the time of computation of the financial leverage of a company, the debt commonly involves LTD or long term debt. The ratios that have been quoted may even omit the present component of the long term debt. The Modigliani-Miller theorem defines the constitution of debt and equity and its impact on the valuation of the firm. Nevertheless, it is quite debatable.

The share market quotes and financial analysis commonly do not take into consideration other liability forms, for example accounts payable. However, some modifications are made to take or omit particular items from the conventional financial statements. In some instances, alterations are also carried out to omit nonphysical properties. This influences the conventional equity and as a result, the debt to equity ratio is also influenced. The economists, financial analysts, as well as research documents denote every type of liability as debt. An accounting identity states that equity summed up with liabilities is equivalent to assets and it is regarded as a precise explanation. Other descriptions of debt to equity ratio do not observe the accounting identity and they must be cautiously examined.

The debt to equity ratio is expressed with the help of the following formula:

Debt to Equity Ratio = D/E = Debt (Liabilities)/Shareholder's Equity

In case of the computation of cost of capital, the equity component of the debt to equity ratio is the market value of the total number of shares or entire equity, not simply the equity of the shareholders.