The debt to equity ratio indicates how much debt and how much equity a business uses to finance its operations.
A company's debt is its long-term debt such as loans with a maturity of greater than one year. Equity is shareholder’s equity or what the investors in your business own. If your business is a small business that is a sole proprietorship and you are the only owner, your investment in the business would be the shareholder’s equity.
The Debt to Equity Ratio
Debt and equity compose a company’s capital structure or how it finances its operations. Debt and equity both have advantages and disadvantages. The debt to equity ratio can be used as a measure of the risk that a business cannot repay its financial obligations.
Debt and equity both have advantages and disadvantages. The debt to equity ratio can be used as a measure of the risk that a business cannot repay its financial obligations.
The debt and equity components come from the right side of the firm’s balance sheet. Debt is what the firm owes its creditors plus interest. In the debt to equity ratio, only long-term debt is used in the equation. Long-term debt is debt that has a maturity of more than one year. Long-term debt includes mortgages, long-term leases, and other long-term loans.
If you have a $50,000 loan and $10,000 is due this year, the $10,000 is considered a current liability and the remaining $40,000 is considered a long-term liability or long-term debt. When calculating the debt to equity ratio, you use the entire $40,000 in the numerator of the equation.
Shareholder’s equity, if your firm is incorporated, is the sum of paid-in capital, the contributed capital above the par value of the stock, and retained earnings. The company’s retained earnings are the profits not paid out as dividends to shareholders. Contributed capital is the value shareholders paid in for their shares.
Shareholder’s equity is the value of the company’s total assets less its total liabilities. The remainder is the shareholder ownership of the company. It is the denominator in the debt to equity equation.
Calculating the Debt to Equity Ratio
The debt to equity ratio is calculated by dividing the total long-term debt of the business by the book value of the shareholder’s equity of the business or, in the case of a sole proprietorship, the owner’s investment:
Debt to Equity = (Total Long-Term Debt)/Shareholder’s Equity
Even though shareholder’s equity should be stated on a book value basis, you can substitute market value since book value understates the value of the equity. Market value is what an investor would pay for one share of the firm's stock.
Understanding the Debt to Equity Ratio
The debt to equity ratio shows a company’s debt as a percentage of its shareholder’s equity. If the debt to equity ratio is less than 1.0, then the firm is generally less risky than firms whose debt to equity ratio is greater than 1.0..
If the company, for example, has a debt to equity ratio of .50, it means that it uses 50 cents of debt financing for every $1 of equity financing.
Firms whose ratio is greater than 1.0 use more debt in financing their operations than equity. If the ratio is less than 1.0, they use more equity than debt.
If a company has a ratio of 1.25, it uses $1.25 in debt financing for every $1 of debt financing.
Understanding the debt to equity ratio in this way is important to allow the management of a company to understand how to finance the operations of the business firm.
This ratio is a measure of financial risk or financial leverage. In the previous example, the company with the 50% debt to equity ratio is less risky than the firm with the 1.25 debt to equity ratio since debt is a riskier form of financing than equity. Along with being a part of the financial leverage ratios, the debt to equity ratio is also a part of the group of ratios called gearing ratios.
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 debt to equity ratio has risen dramatically over time, the company may have an aggressive growth strategy being funded by debt.
If a company’s debt to equity 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 industry average ratios and financial information to determine how the company is using debt and equity as compared to its industry. Companies that are heavily capital intensive may have higher debt to equity ratios while service firms will have lower ratios.