Debt-to-Equity Interpretation

Calculate D/E ratio and assess a firm's leverage.

Problem Scenario

XYZ Inc has total debt of $750K and shareholders' equity of $500K.

Given Data

Total debt$750,000

Total equity$500,000

Requirements

Calculate D/E ratio
Assess leverage level

Solution

Step 1:

D/E = 750,000 / 500,000 = 1.50.

Step 2:

For every $1 of equity, the firm has $1.50 of debt.

Step 3:

This is relatively high leverage—the firm relies heavily on debt financing.

Final Answer

D/E = 1.50. High leverage increases financial risk and potential returns.

Key Takeaways

✓Higher D/E means higher financial risk
✓Compare to industry norms before judging

Common Errors to Avoid

✗Using only long-term debt (include short-term too)
✗Confusing debt-to-assets with debt-to-equity

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FAQs

Common questions about this problem type

Not necessarily. Capital-intensive industries like utilities normally have higher D/E ratios.

As D/E increases, the tax shield lowers WACC initially, but beyond the optimal point, rising cost of equity and debt due to financial distress risk pushes WACC back up. D/E is a key input for understanding capital structure.