Debt to Equity Ratio Formula

A measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. It indicates what proportion of equity and debt the company is using to finance its assets.

 

Note: Sometimes only interest-bearing, long-term debt is used instead of total liabilities in the calculation.

A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense.

If a lot of debt is used to finance increased operations (high debt to equity), the company could potentially generate more earnings than it would have without this outside financing. If this were to increase earnings by a greater amount than the debt cost (interest), then the shareholders benefit as more earnings are being spread among the same amount of shareholders. However, the cost of this debt financing may outweigh the return that the company generates on the debt through investment and business activities and become too much for the company to handle. This can lead to bankruptcy, which would leave shareholders with nothing.

The debt/equity ratio also depends on the industry in which the company operates. For example, capital-intensive industries such as auto manufacturing tend to have a debt/equity ratio above 2, while personal computer companies have a debt/equity of under 0.5.

Debt to Equity Ratio

The debt/equity ratio is important to investors because the more outstanding debt a company has, the greater the proportion of earnings it must use to make payments on the interest and principal. This of course reduces the amount of capital available to help the business grow, to do research, to develop a marketing plan or even to pay dividends to the shareholders.

When a corporation takes on debt, it is locked into making fixed payments, typically twice a year. If it has a bad year, it may not generate enough cash flow to cover the interest payments in which case it must consider selling an asset, raising more money or if the situation persists, possibly declaring bankruptcy.

HIGH vs. LOW RATIOS

A high debt/equity ratio means that the company has been "aggressive" in financing its growth with debt and that it is carrying a sizable amount of interest expense.

A ratio greater than 1 means assets are mainly financed with debt; a ratio less than one means equity provides the majority of the financing.

Ideally, you want to invest in a company where the total debt to equity figure is low -- below .50. However, there are many well-run companies that have a ratio of 1 or even higher. But if the debt-equity ratio surpasses 2, be extremely cautious. Make certain the company can handle its interest payments, and that it has a strong cash flow.

CAUTION: Some companies shift their financing needs to short-term obligations. This makes their long-term debt ratio look better. But, of course, the overall leverage of the firm is the same. Therefore, I recommend that you check the TOTAL DEBT RATIO because this figure includes both short and long term debt.