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The relationship between debt and equity is known as leverage or gearing. This relationship could be simply exhibited in a formula, the debt to equity ratio which is one of the most closely watched ratio by creditors and investors because it reveals the extent to which the company management is willing to fund its operations with debt, rather than equity (Bragg 2010). The formula is: debt to equity ratio = debt / equity. Debts include current liabilities as well as long term debt and equity includes ordinary share capital, reserves and surplus. Some suggest that the debt to equity ratio does not give a true picture of a company’s leverage as it includes current liabilities while it excludes current assets. Thus a more meaningful measure of the financial strength of a company is the long term debt to equity ratio which only considers the relationship between a company’s long term obligations and the owners’ net worth (Agarwal 1982, p.587).
As part of the managing of the funding, it is vital to ensure that the debt to equity ratio of the business as a whole is appropriate. If there is too much debt, a company is known as highly leveraged. The implications of this are that as the interest cost must be met before any dividends can be paid, the risk to shareholders increases. As risk increases, the cost of the debt also increases (Tennent & Friend 2011). It is believed that lenders are particularly concerned about this ratio since an excessively high ratio of debt to equity will put their loans at risk of not being repaid (Bragg 2010).
When using the debt to equity ratio to evaluate a project’s or a company’s financial performance, one need to notice that there is no absolute measurement to evaluate the what the percentage a debt to equity ratio should be in order to best utilize the capital, in another world, there is no best percentage of the debt to equity ratio that all company should follow. A particular company should consider its strategic business goals, industry average debt to equity ratio, competitors’ debt to equity ratio and also a number of internal and external factors in order to identify its own appropriate debt to equity ratio (Gibson 2011, p.268).
The users of the debt to equity ratio not only include the creditor, investors and the shareholders but also include other players in the market that have business relationship with the company such as the banks, financial services companies (credit rating companies), suppliers and even the governments in some extreme cases (bailout in the financial crisis). In another word, any individuals and organizations could be the users of the debt to equity ratio and also because of the easy calculation of the ratio and easy access to the data needed to calculate this ratio (both equities and debts are quested to be made known to the public in the financial report in the public listed firms).