Debt to equity ratio formula

Leverage ratio

The Leverage Ratio measures the financial leverage, i.e. the proportion of debt that a company bears in relation to its equity.  This ratio is calculated by taking all the company’s short- and long-term debts, dividing them by total liabilities (equity plus current and non-current liabilities – also often referred to as shareholders’ equity) and multiplying by 100 to obtain the percentage.  Indebtedness measures, so to speak, the company’s dependence on third parties, whereby the debt ratio specifies the degree to which the company is financially dependent on banks, shareholders or even other companies.

It can be expressed both as a certain percentage and as a percentage of one, because both calculations represent the contributions of third parties to the company’s total financial resources.  Debts refer to the total receivables, i.e. all payments to creditors that must be made both in the long and short term (we will see later how to differentiate between the two terms).

Financial indebtedness

Companies have both their own resources (money provided by shareholders) and borrowed money (liabilities to be repaid) for their operating cycle. Given the different costs of both resources, companies have to find an optimal ratio between the two sources of financing.

Through the debt-to-equity ratio, the company can quickly find out what its equity structure is like and whether it is affordable and efficient. Thus, the debt-to-equity ratio tells us how much the company has borrowed (and is burdened with interest) in relation to what the shareholders have put in out of their own pockets.

Although the calculation is simple when it comes to interpreting it, it is necessary to know how it has been calculated. This is because, depending on the analyst or data provider, it can sometimes be calculated in different ways. In general, net financial debt is considered to be long-term debt (non-current liabilities) and short-term interest-bearing debt (short-term interest-bearing liabilities). These are the debts that generate an interest payment and therefore represent a cost to the company.

Debt/equity ratio

The WACC calculation takes into account the company’s level of equity and its cost, the level of indebtedness and its financial cost, as well as the tax rate that the company must face. Therefore, it takes into account all the company’s sources of resources, whether its own or those of third parties.

For its calculation, all the variables are known in advance except the cost of equity (Ke), which must be obtained separately. The CAPM (Capital Asset Pricing Model) method is used as a general rule. This method assumes that there is a linear relationship between the sector to which the company belongs and the market, with some sectors being more volatile than the market and others less volatile, and therefore performing better (or worse) in expansionary cycles, and vice versa in recessionary cycles. Thus, the formula for obtaining the cost of capital is as follows:

Solvency ratio

The first thing to note is that financial leverage is related to the method of financing the investment company’s activities. That is, the capital structure or the ratio of corporate debt financing to equity financing. Leverage is a form of financing that can be used by companies, groups of investors, families or independent investors in order to increase their investment capital for higher returns.

In other words, the term financial leverage describes the process of borrowing in order to obtain greater investment capital and higher profitability. It can also be understood as the difference between equity capital and the capital actually used in a financial operation. In technical terms, financial leverage enhances the increase in the return on equity over the return on total capital through the participation of foreign capital. The greater the indebtedness, the greater the possibility of profitability.

Eduardo José Cazorla