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Debt/equity ratio is a measure of the proportion of equity versus debt that is used to finance various portions of a company's operations. It is used as a standard for judging a company's financial standing. This ratio is calculated by taking the total liabilities and dividing it by shareholders' equity.
There are a number of variations that can be taken into account when determining a debt/equity ratio. For example, most of the time, liabilities only include long-term debt, such as debt financed through bonds or other forms of business loans. Preferred stock is another example. When determining the debt/equity ratio, it may be counted as an asset or liability.
While companies may have other types of liabilities, such as those listed in an accounts payable ledger, these may or may not be counted as liabilities for the purposes of calculating a debt/equity ratio. In many cases, because they change so often, it may not provide a truly accurate account of liabilities for a company. Therefore, whether they are used is purely a subjective decision made by the company.
Due to the fact not all companies compare the same things when providing a debt/equity ratio, investors should beware. While one company may look better than another, it may all be based on what is being listed as debt and equity. Knowing this is the key to truly understanding how one company compares to another.
Investors will use the debt/equity ratio primarily to determine what amount of risk there may be in either buying equity in the company through stock, or purchasing bonds issued by the company. If the ratio reveals a higher amount of debt compared to equity, investors may consider the company a greater risk. Therefore, they may require a higher interest rate before being enticed to purchase bonds or may not be willing to invest in stock.
Companies that may wish to go to the bond market or keep stock prices above a certain price closely watch their debt/equity ratio. Sometimes, companies may be able to pay off some long-term debt obligations in an attempt to improve this ratio. This could help the company's long-term situation.
One way to do this would be by liquidating assets. While liquidating some assets to pay off debt could be a zero sum game, because debt and equity both decrease, it could be of benefit as well. The company would benefit, for example from not having the interest payments on the debt, which may allow it to build equity quicker. However, substantially changing a debt/equity ratio is something that is not done in a matter of weeks.
The normal level of debt to equity has changed over time, and depends on both economic factors and society's general feeling towards credit. Generally, any company that has a debt to equity ratio of over 40 to 50 percent should be looked at more carefully to make sure there are no liquidity problems.
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