Debt to Equity Ratio
This is an ultimate guide on how to calculate Debt to Equity (D/E) ratio with detailed example, interpretation, and analysis. You will learn how to use its formula to evaluate a firm's debt settlement capacity.
Definition - What is Debt to Equity Ratio?
The debt to equity ratio, also known as liability to equity ratio, is one of the more important measures of solvency that you’ll use when investigating a company as a potential investment.
Essentially a gauge of risk, this ratio examines the relationship between how much of a company’s financing comes from debt, and how much comes from shareholder equity.
The more debt a business takes on to fund its operations, the greater level of risk it assumes, since a higher percentage of its financing is being provided by creditors as opposed to investors.
Most firms take on some level of debt, whether it’s to address cash restrictions in the absence of new investment money coming in, or to buy back some of their stock for the purpose of increasing the overall return on investment of the remaining shares.
But when a business becomes so mired in debt that it’s no longer capable of meeting its financial obligations, it can spell disaster for both the company and its shareholders.
To help avoid this, and to protect their own interests, many lending institutions affix a covenant to their loans that restricts how a business is permitted to use any excess cash, or that limits its allowable ratio of total debt to total equity.
As a potential investor, you’ll want to take similar precautions by looking carefully at the scenario presented by a company’s debt to shareholders' equity ratio.
How do you calculate debt to equity ratio? The debt-equity ratio formula looks like this:
D/E Ratio = Total Liabilities / Total Stockholders' Equity
You should note that, unlike many other solvency ratios, the debt to total equity ratio includes both short-term and long-term liabilities, as well as any outstanding lease amounts.
You can find all of the figures necessary for calculating this ratio on a company’s balance sheet.
Debt To Equity Ratio Calculator
Let’s consider the simplified example of Company J as a potential investment for your portfolio.
By studying Company J’s balance sheet, its total debt to total equity ratio can be calculated as follows:
- Short-Term Liabilities = $450,000
- Long-Term Liabilities = $550,000
- Shareholder Investments (Equity) = $1,000,000
Using these figures and the debt-to-equity ratio formula provided above, you can easily come up with the D/E ratio of this company.
The D/E ratio is calculated as follows:
(With Total Liabilities = Short-term Liabilities + Long-term Liabilities)
Interpretation & Analysis
Now that you know the formula and how to compute the D/E ratio, let's learn how to use it to evaluate a company's solvency.
So what is a good debt to equity ratio?
When the total debt to equity ratio is equal to 1, it means that the assets of a company are equally financed by both creditors and investors.
A total liabilities to equity ratio of over 100% would mean a potentially higher level of financial risk, since creditors lay claim to a larger portion of every asset dollar.
Is it better to have a higher or lower debt to equity ratio?
In general, the lower the liability to equity ratio, the more financially secure a company is, since the majority of its operations are being funded by investor equity rather than by debt.
But it’s important that you determine the appropriate industry benchmark ahead of time for the business you’re analyzing, since some market segments require a higher level of leverage than others.
Cautions & Further Explanation
You should be aware that there are some situations in which a company’s debt to total shareholders' equity ratio can be misleading.
Because the total liabilities figure used in this ratio doesn’t separate out those debts that will have to be repaid in the short term, from those that won’t become due for many years, you should take this information into account when encountering a high liability to equity ratio value.
Furthermore, if a company’s equity is supported by a significant portion of preferred shares, there may be a stock agreement in place that requires the business to pay out a relatively large dividend to its shareholders.
This payment can be substantial enough to affect both a company’s cash reserves, and its subsequent ability to pay down debt.
In a situation like this, the preferred stock behaves more like a liability than a form of equity.