What is debt equity ratio?
The debt equity ratio, also called the debt-to-equity ratio or D/E ratio, is a calculation that shows the relative proportion of shareholders’ equity and debt use to finance the assets of a company. It is one of several financial ratios used to gauge a business’ financial leverage and overall health.
The D/E ratio, the most common financial leverage ratio, is a measure of the relationship between capital that comes from creditors and capital originating from shareholders.
It can also tell us the extent to which stockholders’ equity can meet creditors’ obligations in the event of a liquidation.
If the D/E ratio is too high, it could mean the firm would not survive an interest rate hike or economic downturn.
This type of risk equity is commonly referred to as gearing or risk.
The D/E ratio is calculated by dividing a firm’s total debts (liabilities) by its stockholders’ equity (total value of all its outstanding shares).
Debt Equity Ratio = Total Liabilities ÷ Shareholders’ Equity.
An example of debt equity ratio
Imagine a company, called John Doe Inc., has debts totalling $20,000,000, and stockholders’ equity of $15,000,000.
John Doe’s debt equity ratio is:
20,000,000 ÷ 15,000,000 = 1.33 or 133%.
This means that for every dollar of John Doe belonging to its stockholders, it owes $1.33 to creditors.
Therer are many ways to make the calculation
There are several ways to calculate the D/E ratio. Whoever is presenting the result needs to explain what types of debts were used, as well as whether he or she included the market price (value now) or book price (value when issued) for the equity component.
Some analysts may include all short-term and long-term fixed obligations while others might not. Is preferred stock being considered as debt or equity?
Why is this measure important?
A lower ratio tends to mean that the business is financially healthy. A company with a high debt equity ratio is less likely to generate enough cash to meet all of its debt obligations compared to a firm with a low ratio.
However, if the ratio is very low, it could mean that the firm is not leveraging enough to boost expansion.
Businesses with a lot of assets, such as manufacturers or car rental companies, tend to have higher debt equity ratios compared to companies that are not capital-intensive, such as Google and other tech companies that do not need lots of physical assets to sell their products.
When examining a company’s ratio, it is important to compare it to other businesses in the same industry.
Investors and creditors tend to prefer businesses with low ratios because they are more likely to withstand a sudden spike in interest rates or unexpected hiccups in performance.
The OECD (Organization for Economic Cooperation and Development) says the following regarding debt-to-equity ratio:
“Firms can finance operations through debt or equity. The debt-to-equity ratio is a measure of a firm’s financial leverage, or degree to which companies finance their activities out of equity. It is calculated by dividing the debt of financial corporations by the total amount of shares and other equity liabilities of the same sector.”
Video – Definition of the debt equity ratio
This InvestingAnswers video gives a clear definition of debt equity ratios, and explains why it is an important concept in finance, business and investing.