c





c 

c

 indicates the relationship between the external equities or
outsiders funds and the internal equities or shareholders funds. 

It is also known as ‘
‘
‘‘ 


 . It is determined to ascertain
soundness of the long term financial policies of the company. 

 c
 


ollowing formula is used to calculate debt to equity ratio 

[Debt Equity Ratio = External Equities / Internal Equities]

Or

[Outsiders funds / Shareholders funds]

As a long term financial ratio it may be calculated as follows:

[Total Long Term Debts / Total Long Term unds] 

Or

[Total Long Term Debts / Shareholders unds]

 

The two basic components of Ñ

‘ 


 are outsiders funds i.e. external
equities and share holders funds, i.e., internal equities. The outsiders funds include all
debts / liabilities to outsiders, whether long term or short term or whether in the form of
debentures, bonds, mortgages or bills. The sharehold ers funds consist of equity share
capital, preference share capital, capital reserves, revenue reserves, and reserves
representing accumulated profits and surpluses like reserves for contingencies, sinking
funds, etc. The accumulated losses and deferred expenses, if any, should be deducted
from the total to find out shareholder's funds 

Some writers are of the view that current liabilities do not reflect long term
commitments and they should be excluded from outsider's funds. There are some other
writers who suggest that current liabilities should also be included in the outsider's funds
to calculate debt equity ratio for the reason that like long term borrowings, current
liabilities also represents firm's obligations to outsiders and they are an important
determinant of risk. However, we advise that to calculate debt equity ratio current
liabilities should be included in outsider's funds. The ratio calculated on the basis
outsider's funds excluding liabilities may be termed as ratio of long-term debt to share
holders funds.

 

rom the following figures calculate debt to equity ratio:

Equity share capital 1,100,000

apital reserve 500,000
Profit and loss account 200,000
6% debentures 500,000
Sundry creditors 240,000
Bills payable 120,000
Provision for taxation 180,000
Outstanding creditors 160,000

„  





 



External Equities / Internal Equities

= 1,200,000 / 18,000,000 

= 0.66 or 4 : 6

It means that for every four dollars worth of the creditors investment th e shareholders
have invested six dollars. That is external debts are equal to 0.66% of shareholders
funds.

¦   c
 


Debt to equity ratio indicates the proportionate claims of owners and the outsiders
against the firms assets. The purpose is to get an idea of the cushion available to
outsiders on the liquidation of the firm. However, the interpretation of the ratio depends
upon the financial and business policy of the company. The owners want to do the
business with maximum of outsider's funds in order to take lesser risk of their
investment and to increase their earnings (per share) by paying a lower fixed rate of
interest to outsiders. The outsiders creditors) on the other hand, want that shareholders
(owners) should invest and risk their share of proportionate investments. A ratio of 1:1
is usually considered to be satisfactory ratio although there cannot be rule of thumb or
standard norm for all types of businesses. Theoretically if the owners interests are
greater than that of creditors, the financial position is highly solvent. In analysis of the
long-term financial position it enjoys the same importance as the current ratio in the
analysis of the short-term financial position.


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