Debt to Equity Ratio

Debt to Equity Ratio is a leverage ratio calculated by dividing a company's total liabilities by shareholder equity. D/E Ratio is a measure of financial risk.

What is the Debt to Equity Ratio?

The Debt to Equity Ratio, also called Debt/Equity Ratio or D/E Ratio, is a measure of total debt divided by total equity. D/E ratio is a financial leverage ratio that investors, financial analysts, and lenders use to understand the risk profile of a company.

The debt to equity ratio formula is:

D/E Ratio Formula = (Short-Term Debt + Long-Term Debt) / Total Shareholders’ Equity

D/E Ratio Formula = Total Debt / Total Equity

The debt to equity formula is short-term debt plus long-term debt divided by total equity (common stock plus preferred stock).
All things equal, a lower D/E ratio is safer. Everyone from small business owners to shareholders in a public corporation look at this accounting ratio to understand how a company is financed.

Companies often take on loans to generate additional profit in a strategy called leverage or gearing. Thus, D/E ratio is also known as a gearing ratio or leverage ratio because it provides a clear view into how much debt a company has taken on to generate profit from.

While debt is useful (particular when the terms are favorable), the right balance is a combination of both debt and equity financing. There are also different standards for different industries. Technology startups tend to be heavily financed by equity, whereas manufacturing and transportation companies rely on more debt financing.

How Do I Calculate D/E Ratio?

The debt to equity ratio calculation is:

D/E Ratio = (Short-Term Debt + Long-Term Debt) / Total Shareholders’ Equity

D/E Ratio = Total Debt / Total Equity

Total debt, the numerator, is the sum of all short term and long term debt. Short term debt includes accounts payable, wages payable, short term loans, and the current portion of long-term debt (the portion due this year). Long-term debt includes long-term business loans, capital leases, bonds payable, and other payments to creditors.

Total Debt = Long-Term Loans + Capital Leases + Bonds Payable

Total equity, the denominator, is the amount invested in the company by shareholders plus earnings and less dividends. The equity value is what is left after subtracting out liabilities. This is also called Shareholders’ Equity or Stockholder Equity. To get the firm’s balance sheet to balance, you use this formula:

Total Assets = Total Debt + Total Equity

You can rearrange the balance sheet formula to solve for equity:

Total Equity = Total Assets - Total Debt

Examples of Debt to Equity Ratio

Here are the balance sheets from two example companies that we can use to calculate the debt to equity ratio.

Company A

  • Short-Term Debt: $150,000
  • Long-Term Debt: $670,000
  • Shareholders’ Equity: $500,000

Here is the calculation for Company A:

Debt/Equity Ratio = (Short-Term Debt + Long-Term Debt) / Total Shareholder Equity

Debt/Equity Ratio = ($150,000 + $670,000) / $500,000

Debt/Equity Ratio = $820,000 / $500,000

Debt/Equity Ratio = 1.64x

Company A has a D/E ratio of 1.64x, which means it is financed more heavily with debt than equity. This would be considered a moderate to high amount of leverage, so the borrower should be mindful to not take on excessive debt.

Company B

  • Total Assets: $4,500,000
  • Short-Term Debt: $650,000
  • Long-Term Debt: $1,250,000
  • Total Liabilities: $3,000,000

In this example, we do not have total shareholder equity but we can solve for it by using the balance sheet formula:

Total Assets = Total Liabilities + Total Shareholder Equity

$4,500,000 = $3,000,000 + Total Shareholder Equity

$1,500,000 = Total Shareholder Equity

Now that we know this value, we can calculate debt/equity:

Debt/Equity Ratio = Debt / Equity

Debt/Equity Ratio = ($650,000 + $1,250,000) / $1,500,000

Debt/Equity Ratio = $1,900,000 / $1,500,000

Debt/Equity Ratio = 1.27x

Company B has a higher debt balance than Company A, while still having a lower D/E ratio. The lower D/E ratio is due to Company B having three times more equity.

How is D/E Ratio Used?

Like other leverage ratios, D/E is used to understand how a company is financed. By comparing the company’s outstanding debt to its equity, operators and investors can get a sense of the company’s risk.

All things equal, lenders will find a higher ratio to be higher risk and a lower ratio to be lower risk. As with other accounting ratios, you must consider the stage of company and industry in order to properly assess the D/E ratio. For instance, a high ratio in the technology sector might be deemed low in manufacturing, transportation, or financial services.

In certain cases, companies must maintain a low D/E ratio in order to comply with rules set by their lenders, regulators, or public stock indexes.

Companies with a D/E of 3.0 means that three-quarters of its capital is financed by debt and one-quarter by equity. The math is 3 portions debt for every 1 portion of equity, so there are 4 pieces total.
Debt/equity is one of the most popular leverage ratios.

Other Leverage Ratios

There are other leverage ratios besides the debt/equity ratio. Here are some common ones.

Debt to Capital Ratio

Debt to Capital Ratio, also called Debt/Capital Ratio or D/C Ratio, compares a company’s total debt balance to all capital in the business.

The debt/capital formula is:

Debt/Capital Ratio = Total Debt / (Total Debt + Common Equity + Preferred Equity)

Debt/Capital Ratio = Total Debt / (Total Debt + Total Equity)

Debt to EBITDA Ratio

Debt to EBITDA Ratio, also called Debt/EBITDA Ratio or Debt/EBITDA, compares a company’s total bebt to earnings before interest, taxes, depreciation, and amortization (EBITDA). EBITDA is a measure of profitability that excludes all non-cash transactions.

The debt/EBITDA formula is:

Debt/EBITDA Ratio = Total Debt / EBITDA

Asset to Equity Ratio

The Asset to Equity Ratio, also called Asset/Equity Ratio, compares total assets to total equity. This leverage ratio looks at how the company’s assets are financed.

The asset/equity formula is:

Asset/Equity Ratio = (Current Assets + Fixed Assets) / (Common Equity + Preferred Equity)

Asset/Equity Ratio = Total Assets / Total Equity

A company’s financial leverage is an important consideration. Leverage can tell you about the company’s risk, it’s previous financing, and it’s expectations for the future. If a company has high financial leverage and low growth, then that could be problematic.

Debt vs. Equity Capital Structures

A company’s capital structure refers to how the business is funded. At the end of the day, there are two ways to fund a company – through debt or equity.
Debt refers to money borrowed by a company in exchange for interest. Examples of debt include short-term loans, lines of credit, long-term loans, capital leases, and bonds payable.
Equity refers to money invested in a company in exchange for ownership in the company. Examples of equity include common stock, preferred stock, and additional paid-in capital.

When a company is started, it is usually financed through equity as there is little to no cash flow in the early days. As the business matures and cash flow is generated, it is common to add debt financing to the company’s capital structure.

Debtholders are looking to receive their principle, plus interest, back from the company. Shareholders are looking to see the value of their stock increase over time – this is true for both private and public companies.

Ratios like D/E help us understand how a company is financed and compare their capital structure to established competitors and new entrants. Flags will be raised if a company’s ratio differs significantly from other players in the market.

Final Thoughts

The debt to equity ratio (debt/equity ratio, D/E ratio) is a measure of total short-term and long-term debt divided by total shareholders’ equity. This financial leverage ratio is helpful to executives, managers, and bankers who are assessing the risk profile of a company.

D/E Ratio Formula = (Short-Term Debt + Long-Term Debt) / Total Shareholders’ Equity

D/E Ratio Formula = Total Debt / Total Shareholders’ Equity

The D/E ratio is a quick way of evaluating a company’s debt obligations compared to its equity (sum of common stock and preferred stock). Debt financing can be an effective way of growing a business if there are predictable cash flows. But high debt levels can burden the company, with interest payments eating into profits.

A company’s balance sheet shows assets, liabilities, and equity. The balance sheet and key leverage ratios will help you understand a firm’s standing against competitors and whether the company’s financial leverage is viable.

At the end of the day, businesses need enough cash to be self-sustaining. Taking on additional debt can be justified if the profit exceeds the debt’s cost. But taking on too much leverage can be problematic and scare away potential investors.

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