Chapter 12
Using Accounting Information
373
Debt-to-Equity Ratio
The
debt-to-equity ratio
is used to assess the balance of debt and equity in a business. The debt-
to-equity ratio is calculated as shown below.
=
Total Liabilities
Debt-to-Equity Ratio
Total Shareholders’ Equity
It is not healthy for a business to borrow too much
relative to what it is worth.This is because there is
a cost of debt in the form of interest.The industry
the business is in usually influences how much
should be borrowed. For example, capital-intensive
industries such as auto manufacturers have higher
debt-to-equity ratios than software developers.The
past two debt-to-equity ratios for Second Cup are calculated in Figure 12.22.The industry averages
are also shown for comparison purposes.
2014
2013
Total Liabilities
$28,455
$31,376
Shareholders’ Equity
$24,994
$45,964
Debt-to-Equity Ratio
1.14
0.68
Industry Average
2.08
2.24
_______________
Figure 12.22
As you can see, the debt-to-equity ratio has increased from 2013 to 2014 and has risen above 1.
This is not a good sign, especially considering the significant decrease in shareholders’ equity. It
implies that Second Cup has suffered a loss and was unable to pay off much debt during the year.
However, Second Cup’s debt-to-equity ratio is still much lower than the industry average.
There are a few ways a business can improve the debt-to-equity ratio. First, making more profit
might do the trick (although it is easier said than done), since it directly results in an increase to
shareholders’ equity. Second, the business might think about issuing more shares in exchange for
cash.
The Cash Flow Statement
Accountants are required to prepare balance sheets and income statements for the business.These
important documents represent the state of company finances and adhere to accounting principles.
As such, balance sheets and income statements are filled with promises of an exchange of money
Acquiring loans or paying back loan
principals has no effect on equity.
WORTH REPEATING
