Debt Equity Ratio

How much leverage does a company have?

What is the debt equity ratio?

The Debt Equity ratio (also called the “debt to equity ratio”, “risk ratio” or “gearing”), is a leverage ratio that calculates the weight of total debt and financial liabilities against the total shareholder’s equity. Unlike the debt ratio which uses total assets as a denominator, the debt to equity ratio uses total equity. This ratio highlights how a company’s capital structure is tilted either toward debt or equity financing.

debt equity ratio formula

Debt equity ratio formula

Short formula:

Debt to Equity Ratio = Total Debt / Shareholders’ Equity

Long formula:

Debt to Equity Ratio = (short term debt + long term debt + fixed payment obligations) / Sharehoders’ Equity

 

Debt to equity ratio in practice

If, as per the balance sheet, the total debt of a business is worth $50 million and the total equity is worth $120 million, then debt-to-equity is 0.42. This means that for every dollar in equity, the firm has 42 cents in leverage. A ratio of 1 would imply that creditors and investors are on equal footing in the company’s assets.

A higher debt equity ratio indicates a levered firm, which is quite preferable for a company that is stable with significant cash flow generation, but not preferable when a company that is in decline. Conversely, a lower ratio indicates a firm less levered and closer to being fully equity financed. The appropriate debt to equity ratio varies by industry.

The appropriate debt to equity ratio varies by industry.  Learn all about this step by step in our FREE corporate finance course!

 

What is total debt?

A company’s total debt is the sum of short-term debt, long-term debt, and other fixed payment obligations (such as a capital lease) of a business that are incurred while under normal operating cycles. Creating a debt schedule helps split out liabilities by specific pieces.

Not all current and non-current liabilities are considered debt.  Below are some examples of things that are and are not considered debt.

Considered debt:

  • Drawn line of credit
  • Notes payable (maturity within a year)
  • Current portion of Long Term Debt
  • Notes payable (maturity more than a year)
  • Bonds payable
  • Capital lease obligations

Not considered debt:

  • Accounts payable
  • Accrued expenses
  • Unearned revenues
  • Dividends payable

 

Benefits of a high debt equity ratio

A high debt equity ratio can be good when a firm can easily service its debt obligations (through cash flow) and is using the leverage to increase equity returns.

In the example below, we see how using more debt (increasing the debt equity ratio) increases the company’s return on equity (ROE).  By using debt instead of equity, the equity account is smaller and therefore return on equity is higher.

Another benefit is that typically the cost of debt is lower than the cost of equity, and therefore increasing the D/E ratio (up to a certain point) can lower a firm’s weighted average cost of capital (WACC).

debt equity ratio ROE impact example

 

This is covered in step by step detail in our FREE corporate finance course!

 

Drawbacks of a high D/E ratio

The opposite of the above example applies if a company has a D/E ratio that’s too high.  In this case, any losses will be compounded down and the company may not be able to service its debt.

If the debt equity ratio gets too high, the cost of borrowing will skyrocket, as will the cost of equity, and the company’s WACC will get extremely high, driving down its share price.

 

More resources

The keep learning and developing your knowledge of financial analysis we highly recommend these additional resources: