Study: Solvency Ratios: Debt Ratio, Debt-Equity Ratio
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This topic tests your understanding of two solvency ratios: Debt Ratio - Slide 8 (1m:50s)
Links to an external site. Debt-Equity Ratio - Slide 9 (2m:14s)
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Slide 8 (1m:50s):
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Solvency Ratios: Here are a couple other computations that are interesting to users:
Solvency: Debt Ratio
Links to an external site.: Total liabilities/Total assets
Users compute a company's debt ratio
Links to an external site. to assess what percentage of the company's assets were funded by debt. A debt ratio of 1 indicates that for every $1 of asset, the company has $1 of liabilities. In other words 100% of the company's assets were funded by debt and the company is VERY highly leveraged
Links to an external site., in fact the company is bordering on technical insolvency. If the debt ratio is greater than 1, it would indicate that for every $1 of asset, the company has more than $1 of liabilities. This is not a good situation and the company would be described as being "technically insolvent". This is an example of leverage going out of control. A debt ratio below one means that for every $1 of assets, the company has less than $1 of liabilities, hence being technically "solvent
Links to an external site.". Debt ratios less than 1 reveal that the owners have contributed the remaining amount needed to purchase the company's assets.
Here are XYZ's debt ratios for 20X8 and 20X7:
20X8 20X7
Debt ratio .91 .54
(debt ratio computations: 20X8: Total liabilities $131,000 / $144,000 Total assets = .91; 20X7: Total liabilities $70,000 / $130,000 Total assets = .54)
Based on XYZ's debt ratios above, it is clear that XYZ is on a negative trend toward insolvency as its liabilities increase as a percentage of its assets. Lenders and investors seeing this trend should be very cautious.
Slide 9 (2m14:s):
Links to an external site.Solvency: Debt to Equity Ratio
Links to an external site. : Total liabilities/Total equity
And that should make sense because it is "debt to equity", that's one way to read these. The other one, the debt ratio, its to debt to assets, but we just call it the debt ratio. At any rate, The debt to equity ratio
Links to an external site. is similar to the debt ratio in its focus on a company's leverage, that's long-term solvency, but it tries to show the relative proportion of how assets were funded either by debt or by equity. So, in other words, assets are equal to liabilities and equity, so if we see these relative proportions, it will help us understand how the assets were funded.
If total liabilities are greater than total equity, the debt to equity ratio will be greater than 1 indicating that more than 50% of the company's assets have been funded by debt. If this ratio grows larger every year, the company is becoming more highly leveraged by debt.
If the debt to equity ratio is exactly 1, it indicates that exactly 1/2 of all assets were funded by debt and the other 1/2 were funded by equity.
As the debt to equity ratio continues to drop below 1, so if we do a number line here and this is one, if it's on this side, if the debt to equity ratio is lower than 1, then that means its assets are more funded by equity. If it's greater than one, its assets are more funded by debt. So as the debt to equity ratio continues to drop below one it indicates the company is reducing its reliance on debt to fund assets and its leverage is going down. It also means that the owner's ownership % of assets is going up.
So here are XYZ's debt to equity ratios for year 20X8 and 20X7:
20X8 20X7
Debt ratio 10.08 1.17
(debt ratio computations: 20X8: Total liabilities $131,000 / $13,000 Total equity = 10.08; 20X7: Total liabilities $70,000 / $60,000 Total assets = 1.17)
So as you can see, it's growing along this number line, that means that we are getting more liabilities in relation to equity to fund the assets. XYZ's debt to equity ratio significantly increased from only 1.17, where liabilities and equity funded XYZ's assets almost equally, all the way up to 10.08 indicating an almost complete reliance on debt to obtain assets, which is a very high level of leverage.