Question

Question: Describe the debt-to-equity ratio and explain how creditors and owners would use this ratio to evaluate a company’s risk.

Short answer

Answer

$\text{Debt - to - equity} \text{ratio}=\frac{\text{Total Liabilities}}{\text{Total Equity}}$

A company financed mainly with debt is riskier because this situation sometimes creates problems in the business operations because of interference of creditors.

Step-by-step solution

Meaning of Debt-to-equity Ratio

The debt-equity ratio is a long-term solvency ratio showing a relative measure of debt and equity financing the business entity's assets.

Explanation regarding the use of debt to equity ratio by the creditors and the owners

Creditors use the debt-to-equity ratio to determine whether the company can repay the loan amount to creditors. A low ratio is considered favorable by the creditors.

Owners can use this ratio to determine that if the company has a high debt-to-equity ratio, the creditors have more claims than the owners, which is unfavorable according to the owner's view.

Example:

A company's debt-to-equity ratio is 4.5, meaning that debt holders contributed $4.5 for each $1 contributed by equity holders.