Debt equity ratio

Meaning: this ratio establishes a relationship among long term debts and share holders funds.

Objective: the objective of computing this ratio is to measure the relative proportion of debt and equity in financing the assets of a firm.

Components: there are two components of this ratio which are as under:

Long term debts: which mean long term loans (whether secured or unsecured (e.g., debentures bonds loans from financial institutions).

Shareholders funds: which mean equity share capital plus preference share capital plus reserves and surplus minus fictitious assets(e.g., preliminary expenses)

Computation: this ratio is computed by dividing the long term debts by the shareholders funds. This ratio is usually expressed as a pure ratio e.g, 2:1. in the form of a formula this ratio may be expressed as under:

Interpretation: it shows the margin of safety to long term creditors. A low debt equity ratio implies the use of more equity than debt which mean a larger safety margin for creditors since owner equity is treated as a margin of safety by creditors and vice versa.