1571--The debt to equity ratio

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1571--The debt to equity ratio Powered By Docstoc
					The debt to equity ratio (D/E) is a financial ratio indicating the relative proportion of
equity and debt used to finance a company's assets. This ratio is also known as Risk or
Gearing. It is equal to total debt divided by shareholders' equity. The two components are
often taken from the firm's balance sheet or statement of financial position (so-called
book value), but the ratio may also be calculated using market values for both, if the
company's debt and equity are publicly traded, or using a combination of book value for
debt and market value for equity.

Preferred shares can be considered part of debt or equity. Attributing preferred shares to
one or the other is partially a subjective decision but will also take into account the
specific features of the preferred shares.

When used to calculate a company's financial leverage the debt usually includes only the
Long Term Debt (LTD). Quoted ratios can even exclude the current portion of the LTD.
The composition of equity and debt and its influence on the value of the firm is much
debated and also described in the Modigliani-Miller theorem.

Financial analysts and stock market quotes will generally not include other types of
liabilities, such as accounts payable, although some will make adjustments to include or
exclude certain items from the formal financial statements. Adjustments are sometimes
also made to, for example, exclude intangible assets, and this will affect the formal
equity; debt to equity will therefore also be affected.

Financial economists and academic papers will usually refer to all liabilities as debt, and
the statement that equity plus liabilities equals assets is therefore an accounting identity
(it is, by definition, true). Other definitions of debt to equity may not respect this
accounting identity, and should be carefully compared.

       D/E = Debt (Liabilities)/ Equity

(Sometimes only interest-bearing long-term debt is used instead of total liabilities in the

A similar ratio is debt-to-total assets (D/A), also known as debt-to-value:

       D/A = debt / assets = debt / (debt + equity)

The relationships between D/E and D/A are:

       D/A = D/E / (1 + D/E)
       D/E = D/A / (1 – D/A)

In the financial industry (particularly banking), a similar concept is equity to total assets
(or equity to risk-weighted assets), otherwise known as capital adequacy:
         Capital Adequacy = E / A

Since D + E = A (by the accounting equation), D/A + E/A = 1, so E/A = 1 - D/A. For
instance, if a company has 10% capital adequacy, they have 90% debt-to-assets.

[edit] Background

On a balance sheet, the formal definition is that debt (liabilities) plus equity equals assets,
or any equivalent reformulation. Both the formulas below are therefore identical:

         E = A – D or D = A – E

Debt to equity can also be reformulated in terms of assets or debt:

         D/E = D /(A – D) = (A – E) / E

[edit] Example
General Electric Co. ([1])

        Debt / equity: 4.304 (total debt / stockholder equity) (340/79)
        Other equity / shareholder equity: 7.177 (568,303,000/79,180,000)
        Equity ratio: 12% (shareholder equity / all equity) (79,180,000/647,483,000)

[edit] Cost of capital
In a cost of capital calculation the equity in the debt/equity ratio is the market value of all
equity (all shares), not just shareholders' equity

Financial leverage

The degree to which an investor or business is utilizing borrowed money. Companies that are highly
leveraged may be at risk of bankruptcy if they are unable to make payments on their debt; they may also be
unable to find new lenders in the future. Financial leverage is not always bad, however; it can increase the
shareholders' return on their investment and often there are tax advantages associated with borrowing. also
called leverage.

'financial leverage ' appears in the definitions of these terms on

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