Debt-to-Equity Ratio

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Definition

The debt-to-equity ratio (debt/equity ratio, D/E) is a financial ratio indicating the relative proportion of entity's equity and debt used to finance an entity's assets. This ratio is also known as financial leverage.

Debt-to-equity ratio is the key financial ratio and is used as a standard for judging a company's financial standing. It is also a measure of a company's ability to repay its obligations. When examining the health of a company, it is critical to pay attention to the debt/equity ratio. If the ratio is increasing, the company is being financed by creditors rather than from its own financial sources which may be a dangerous trend. Lenders and investors usually prefer low debt-to-equity ratios because their interests are better protected in the event of a business decline. Thus, companies with high debt-to-equity ratios may not be able to attract additional lending capital.

Calculation (formula)

A debt-to-equity ratio is calculated by taking the total liabilities and dividing it by the shareholders' equity:

Debt-to-equity ratio = Liabilities / Equity

Both variables are shown on the balance sheet (statement of financial position).

Norms and Limits

Optimal debt-to-equity ratio is considered to be about 1, i.e. liabilities = equity, but the ratio is very industry specific because it depends on the proportion of current and non-current assets. The more non-current the assets (as in the capital-intensive industries), the more equity is required to finance these long term investments.

For most companies the maximum acceptable debt-to-equity ratio is 1.5-2 and less. For large public companies the debt-to-equity ratio may be much more than 2, but for most small and medium companies it is not acceptable. US companies show the average debt-to-equity ratio at about 1.5 (it's typical for other countries too).

In general, a high debt-to-equity ratio indicates that a company may not be able to generate enough cash to satisfy its debt obligations. However, a low debt-to-equity ratio may also indicate that a company is not taking advantage of the increased profits that financial leverage may bring.

Exact Formula in the ReadyRatios Analytical Software

Debt-to-equity ratio = F1[Liabilities] / F1[Equity]

F1 – Statement of financial position (IFRS)

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