Debt to equity ratio is used to evaluate a company’s financial leverage and is calculated by dividing a company’s total liabilities by its shareholder equity, the ratio is an important metric in corporate finance. It is a measure of the degree to which a company is financing its operations with debt rather than its own resources, so the ratio is a particular type of gearing ratio.
Equation: Debt to Equity = Total Liabilities / Total Shareholders’ Equity
Debt to Equity ratio measures how much debt a company has taken on relative to the value of its assets net of liabilities. Debt must be repaid or refinanced, imposes interest expense that typically can’t be deferred, and could impair or destroy the value of equity in the event of a default. As a result, a high Debt to Equity ratio is often associated with high investment risk; it means that a company relies primarily on debt financing.
Debt-financed growth may serve to increase earnings, and if the incremental profit increase exceeds the related rise in debt service costs, then shareholders should expect to benefit. However, if the additional cost of debt financing outweighs the additional income that it generates, then the share price may drop. The cost of debt and a company’s ability to service it can vary with market conditions. As a result, borrowing that seemed prudent at first can prove unprofitable later under different circumstances.
Changes in long-term debt and assets tend to affect Debt to Equity ratio the most because the numbers involved tend to be larger than for short-term debt and short-term assets. If investors want to evaluate a company’s short-term leverage and its ability to meet debt obligations that must be paid over a year or less, they can use other ratios.
What counts as a “good” debt to equity ratio will depend on the nature of the business and its industry. Generally speaking, a debt to equity ratio below 100% would be seen as relatively safe, whereas values of 200% or higher might be considered risky. Companies in some industries, such as utilities, consumer staples, and banking, typically have relatively high ratios. Note that a particularly low ratio may be a negative, suggesting that the company is not taking advantage of debt financing and its tax advantages.