The debt-equity ratio is determined to ascertain the soundness of the long-term financial policies of the entity. This ratio indicates the proportion between the shareholders’ funds (i.e. Tangible net worth) and the total borrowed funds. Ideal ratio is 1.
debt to equity ratio = total debt/total equity
Debt/Equity=Total Shareholders’ Equity Total Liabilities
In other words, the investor may take debt equity ratio as quite satisfactory if shareholders’ funds are equal to borrowed funds. However, creditors would prefer a low debt-equity ratio as they are much concerned about the security of their investment. This ratio can be calculated by dividing the total debt by shareholders’ equity. For the purpose of calculation of this ratio, the term shareholders’ equity includes share capital, reserves and surplus and borrowed funds which includes both long-term funds and short-term funds.
A high ratio indicates that the claims of creditors are higher as compared to owners’ funds and a low debt-equity ratio may result in a higher claim of equity.