Debt-to-Equity Ratio: How It's Calculated and What It Measures
Debt on a company’s balance sheet represents certain financial obligations it has taken on to support its business. Calculating a company’s debt to equity ratio helps company management, lenders, and creditors understand the riskiness of the company's financial structure. The ratio offers insight into the company's financing decisions and can shed light on the probability of the business having difficulty meeting its debt repayment 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, the current portion of any long-term debt obligations, and accrued expenses, such as salaries payable and interest payable. Debt also includes long-term obligations, meaning those having a maturity of more than one year, such as mortgages and long-term leases.
Equity represents the combination of shareholder’s equity (cash paid in by investors when the company sells its stock) and the company’s retained earnings (profits not paid out as dividends to the company’s shareholders).
Doing the Calculation
Calculate the debt to equity ratio using the following equation:
Debt/Equity = Total Debt/Shareholder’s Equity
On the balance sheet, use the total debt, which includes short-term debt (current liabilities) and long-term balances.
Locate the equity number in the last section of the balance sheet, using the total shareholders' equity amount.
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 a company has a debt to equity ratio of 50 percent, this comes close to the U.S. average debt to equity ratio of 54.62 percent, according to Statista.com.
This percentage is an indicator of debt the company has used to finance its assets, such as equipment and buildings. Companies in equipment-heavy industries such as manufacturing may have a higher debt to equity result, reflecting the greater investment in machinery, warehouse space, and other manufacturing-specific assets. In this case, the higher debt percentage may be standard for the industry and does not mean the company is of higher risk or will have trouble servicing its debt.
Interpreting the Results
As with any ratio, the debt to equity ratio is more meaningful 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 adds additional risk to the company and increases expenses due to the higher interest costs from the increase in debt.
The debt to equity ratio can be misleading unless examining the components at a detailed level. A company’s equity could contain a large proportion of preferred stock with dividend payments mandated by the preferred stock agreement. This arrangement affects the amount of available cash flow to pay the debt and causes this type of equity to take on some features more characteristic of debt due to the liability of the upcoming dividend payments.
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. If a large chunk of debt is due to be paid within the year, the ratio could appear to fluctuate drastically. For this reason, comparing the same ratio from several different time periods would give more meaningful insight and information.