Learn the toughest concepts covered in your Financial Accounting class with step-by-step video tutorials and practice problems.

14. Financial Statement Analysis

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Ratios: Debt to Equity Ratio

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So here we go with another ratio. The debt to equity ratio. So the debt to equity ratio, It's going to help us analyze how companies assets are financed. Okay, that's equity ratio, it's a common leverage ratio leverage ratios deal with the amount of debt that we have. Right leverage is always talking about debt, highly leveraged company has a lot of debt. Cool. So remember that our our fundamental equation assets equal liabilities plus equity, well, assets, that's everything the company owns and then this is how they're financed. The liabilities and the equity liabilities is what we owe to others. And equity is what's owned by the company, by the shareholders of the company. Now you may have learned about the debt ratio as well. Right, I don't want you to confuse the debt to equity ratio with the debt ratio. The debt ratio compares total liabilities to total assets. Right. So our numerator is total liabilities divided by total assets in our denominator. Okay, so that's our debt ratio. Notice this ratio, debt to equity as we have in our box here. Well, we've got our total liabilities divided by total equity in this case. Right. So how do we analyze this? Remember that every ratio is gonna tell us how much of the numerator for each one of the denominator. So how many dollars of debt for each dollar of equity that we have? So you can imagine that a debt debt to equity ratio above 1.0, anything above one? It's going to imply that the company relies more on debt than equity. Right? Because how are we gonna get a number bigger than one? Well, that's if the numerator is bigger than the denominator, right, so liabilities would have to be more than equity. Now, when is when is this a little more of a red flag is when they have a very high ratio? Right? That means that the company is highly levered, right? They're highly leveraged. They have a lot of leverage because they're gonna depend more on the loans than the equity financing. So this implies that they're risky. Right? It's a riskier company because they have a lot of loans. And why does that make them risky? When you have a lot of loans? That means you're gonna have a lot of interest payments. Right. And those interest payments aren't gonna go away when you finance with equity? Well, you pay dividends to the, to the shareholders, but you don't necessarily have to pay those dividends, right? You can hold off on dividends, but interest expense, you're gonna have to pay it. So that adds this fixed expense that you're definitely gonna have to cover if you can't cover it? Well, you're gonna be in trouble. Cool. So high ratio implies more risk. Cool. Alright, this is a pretty easy ratio. Why don't we just jump into some practice problems right away, Let's do it now

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Problem

On its December 31 balance sheet, XYZ Company reported total assets of $880,000 and total liabilities of $560,000. What is the company’s debt to equity ratio?

A

.64

B

.36

C

.57

D

1.75

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Problem

At the beginning of the year, ABC Company had total assets of $600,000, Total Liabilities of $360,000, and Total Equity of $240,000. At the end of the year, total assets had increased to $800,000, Total Liabilities decreased to $320,000 and Total Equity increased to $480,000. What was the change in the company’s debt to equity ratio during the year?

A

Increase by 0.83

B

Increase by 0.20

C

Decrease by 0.83

D

Decrease by 0.20

E

No change in the debt to equity ratio

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