How to Calculate the Debt to Equity Ratio

Solvency ratios help us determine what portion of a company’s assets come from its shareholders (owners) and what portion comes from debt financing such as long term loans, lines of credit, bonds, etc. The relationship between debt and equity in the business is best described by the debt to equity ratio. The debt to equity ratio expresses total liabilities as a percent of total assets. The formula for debt to equity ratio is:

Debt to Equity ratio = Total Liabilities / Shareholder’s Equity

Example to Calculate Debt to Equity Ratio

Let’s calculate the debt to equity ratio for Juakali Corp. for the 2004 year using its balance sheet as above.

With this, we can see that 51.01% of Juakali Corp. is owned by its creditors and almost 49% is owned by its shareholders. A company with a very high debt versus equity is considered very risky because it go bankrupt very soon if it does not generate sufficient cash flows to meet its debt obligations. A company such as this with a mix of debt and equity is mild risk, because in this case, still the debts outweigh the equity.

From a shareholders’ point of view, including debt in the capital structure of a company is acceptable so long as the risk is not too great, and that the return on borrowed capital is greater than the cost of borrowing the debt (Weighted Average Cost of Capital). For instance, if Juakali Corp. borrows $200 thousand from the bank and invests in opening new stores that are projected to increase revenues of the company by 25%, and if the interest rate payable on the debt is 10%, then this is desirable because the return from borrowed capital outweighs the cost of borrowing the capital (10%).

Sometimes debt can have the effects of increasing the return to shareholders and is thus described as gaining financial leverage. A firm is considered highly leveraged if a large portion of its company’s assets are financed by debt.

How to Calculate Debt to Equity Ratio

View this simple video from Investopedia.com that shows how Debt to Equity ratio is calculated. It shows how Joe's Debt to Equity ratio is 5 while Steve's debt to equity ratio is 0.5. A high debt to equity ratio generally means:

• The company has been agressively financed using outstanding debt, which can result in volatile earnings due to additional interest expense.

It is interesting to note how Joe`s application is classified as high risk and declined (debt to equity ratio of 5 times) while Steve`s application was accepted due to his low debt to equity ratio of just 0.5.

Can a Company Swap its Debt for Equity

Yes it sure can! Here`s a real life example from Ambac Financial Group (Public, NYSE:ABK).

New York - June 18, 2010

Bond insurer Ambac Financial Group Inc. has reached deals with certain holders of its own bonds to swap debt for stock in a move to preserve cash and shore up its balance sheet. The agreements call for the company to issue more than 5 million shares of common stock in exchange for $8.5 million in debt. The issuance will bring Ambac to a total of 293.4 million common shares outstanding. The deal may help Ambac crawl back from the brink of bankruptcy.

The company earlier this month said it could default on its debt and issued its latest warning that it could file for bankruptcy protection. It was the embattled company's latest warning amid two years of struggle to regain its footing after getting pummeled by the collapse of the housing market.

The company did post a profit for the 2009 fourth quarter, but returned to a loss for the first quarter of this year, due in part to accounting standards put into place after the Wisconsin insurance commissioner's actions.

The stock-for-debt swap encouraged some investors. The company's battered stock added 2 cents to close at 80 cents. The once lofty equities traded over $95 a share two years ago, but haven't topped $3.39 in the past 52 weeks.