Debt-To-Equity Ratio: Calculation and Measurements
Debt on a company’s balance sheet represents the financial obligations it has accrued to finance its business operations. Calculating a company’s debt-to-equity ratio helps management, lenders, and creditors understand the financial structure of the company.
The debt to equity ratio indicates how a company uses debt. Debt is typically used to finance asset purchases, such as necessary equipment, which give the business equity (in asset value).
Depending on the company and industry, this ratio can be used as a measurement of risk. Risk, in this sense, is the inability to pay the business' financial obligations.
The Debt and Equity Components
Debt includes a company’s current and long-term liabilities. Current liabilities, which the firm intends to pay off in one year or less, include accounts payable (money you owe), accrued expenses (such as sales tax payable), interest payable, and current portions of long-term debt.
Current portions of long-term debt are simply what your business must pay this year on debt. If you have a $50,000 loan, and $10,000 of it is due this year, the $10,000 you owe is your current portion of long term debt.
Debt is also your business' long-term obligations. These are debts that have a maturity of more than one year, such as mortgages or long-term leases.
Equity represents the combination of shareholders' equity, the company’s retained earnings, par value of stocks, and contributed capital above par value. Par value is the value of shares should the firm fail, usually listed in the company charter.
Contributed capital is the value shareholders paid in for their shares. Retained earnings are profits not paid out as dividends to the company’s shareholders.
Shareholder's equity is the value of your total assets less your total liabilities. The remainder is the shareholder ownership of the company.
Calculating the Ratio
Your balance sheet has the information you need to calculate the debt to equity ratio. Add your current and long-term liabilities to get your total debt, and subtract your total liabilities from your total assets for total equity. The following equation is used:
Debt (Total Debt) ÷ Equity (Total Equity)
Understanding the Debt-To-Equity Ratio
The debt-to-equity ratio reveals a company’s debt as a percentage of its total market value. If your company has a debt-to-equity ratio of 50%, it means that you have $.50 of debt for every $1 of equity.
Ratios higher than 1 indicate you have more debt than equity, and a ratio of less than 1 reveals you have less debt than equity. Lower ratios are generally considered to be more desirable, depending on your industry.
Companies in equipment-heavy industries such as manufacturing or construction may have a higher debt-to-equity ratio. This is due to greater investment in machinery, warehouse space, and other manufacturing or construction assets.
In this case, the higher debt percentage may be standard for the industry and does not mean the company has higher financial risk, or problems paying its debts.
Interpreting the Results
As with any ratio, the debt-to-equity ratio offers more meaning and insight when compared to the same calculation for different historical financial periods. If a company’s ratio has risen dramatically over time, the company may have an aggressive growth strategy being funded by debt.
This increasing leverage (using debt to finance growth) adds additional risk to the company and increases expenses due to the higher interest costs and debt.
The debt-to-equity ratio can be misleading unless it is used along with other ratios and financial information to determine how the company is using the debt and how it generates revenues.
If the debt is used to purchase equipment that will generate income for the following year (or period), the debt-to-equity ratio may not be useful.
The debt-to-equity ratio also does not consider whether a large portion of the debt is due in the near term or the long term. For this reason, comparing the same ratio from several different time periods would give more meaningful insight and information.