The proportion of debt ratios indicate what proportion of the firm’s capital is derived from debt compared to other sources of capital such as common stock, preferred stock and retained earnings. The extent to which a firm uses financial leverage defines if the firm earns more on investments financed with borrowed funds than it pays in interest. This means that its financial risk increases to the extent that creditors look up on the firm’s equity to provide a margin of safety. Debt to Equity ratio is a ratio that measures the financial risk that a firm undertakes and it is calculated as follows: Debt to Equity ratio = Total Long Term Debt / Total Equity = (Non-current Liabilities + Deferred Taxes + PV of Lease Obligations) / Total Equity Analyzing the Debt components As the formula indicates the debt figure includes all long-term fixed obligations including non-current liabilities, deferred taxes and PV of lease operations. In particular: Non- current liabilities: include also subordinated convertible bonds. Deferred taxes: deferred taxes are typically considered liabilities. However, when calculating debt/equity ratio, analysts should take into consideration that deferred taxes are accumulated in straight-line depreciation and therefore as firm grows and its assets grow, deferred taxes grow equally. PV of lease obligations: when operating leases exist, it is necessary to include an estimate of the present value (PV) of the lease payments as long-term debt. Defining Total Equity The equity is typically the book value of the equity and it includes preferred stock, common stock, and retained earnings. ExampleWe need to calculate the financial risk of firm X using all debt components in order to show the effect of each one of them in the ratio calculation. In particular:Non-current liabilities = 562$ ml Deferred taxes = 228$ ml PV of lease obligations = 9,504$ ml Total Equity = 7,196$ ml. Applying above figures to the formula we derive Debt to Equity ratio = (562+228+9,504) / 7,196 = 10,294 / 7,196 = 143.1%If we do not include the PV of lease obligations then ratio would be Debt to Equity ratio = (562+228) / 7,196 = 790 / 7,196 = 10.98%A higher proportion of debt capital compared to equity capital indicates higher financial risk and increases the probability that the firm could default on the debt. In the above example, by not including the PV of lease obligations in the calculations we derive a significantly lower Debt to Equity ratio. This indicates the importance of the significant impact of including the estimate of the present value (PV) of the lease payments as long-term debt. Category:Home › Other • Pomegranates: A newly discovered superfood • Where did the joke why did the chicken cross the road come from and why is it funny? • Can mothers diagnosed with bipolar disorder make good parents? • Spiritual evolution of human consciousness • Tips for getting a college basketball scholarship • Living with Pseudotumor cerebri (PTC) • Caring for the caregiver • Technologys impact on society