How to Determine a Debt Equity Mix

Debt or Equity

Capital is everything in the world of finance. Businesses need capital (money) in order to grow and investors provide businesses with capital in the form of both debt (bonds) and equity (stocks).
Debt represents a claim against the company and the company pays the investor interest to compensate them for the use of investment funds. This interest is tax deductible.
Equity represents a claim against future earnings of the company and the company is not obligated to pay the company back. Both investments have different costs associated with obtaining the use of funds and so determining a company's debt to equity mix can provide significant insights into the company's capital structure.

Things You'll Need

• Calculator or spreadsheet

Instructions

1. Obtain the balance sheet for the company in question. You can usually obtain the balance sheet from the company website or by calling Investor Relations for the company. The balance sheet is usually the first or second financial statement in the annual report.

2. Determine the amount of debt the company has. Debt is listed under Liabilities and consists of bonds and other long term note payable. Add both short and long term debt for total debt.

3. Determine the amount of equity the company has. You will find information on equity in the Stockholder's Equity section of the balance sheet. Equity is classified as common stock, preferred stock or retained earnings. Sum these line items for total equity.

4. Calculate the company's debt-to-equity ratio. Investors use the debt to equity ratio as a measure of riskiness. Too much debt is a sign of financial inflexibility. The calculation is debt divided by equity. For instance, if your company's total debt is $100,000 and the total equity is $50,000 then the debt to equity ratio is 2 ($100,000/$50,000).

5. Interpret the debt to equity ratio. A high debt to equity ratio signifies a high mix of debt of debt to equity and vice-versa.

Tips & Warnings

• While debt has certain tax advantages it is usually more expensive for the company to issue than equity so investors usually prefer a higher mix of equity over debt.

References

• Investopedia: Capital Structure