Debt to Equity

Debt to equity is a financial liquidity ratio that measures the total debt of a company with the total shareholders’ equity. It shows the percentage of financing that comes from creditors or investors (debt) and a high debt to equity ratio means that more debt from external lenders is used to finance the business.

It is very common for a company to use debt to grow and they can do this by using creditor financing (a bank loan) or investor financing (selling shares in the company).

The debt and equity of a company can be found on the balance sheet and, in business terms, are often referred to as liabilities (debt) and total stockholder’s equity (equity).

Debt to Equity Formula

Debt\: to\: Equity = \dfrac{Total\: Liabilities}{Total\: Equity}

Once you have the total liabilities and equity numbers from the balance sheet, you can calculate the debt to equity ratio by dividing liabilities by equity.

The debt to equity ratio is a balance sheet ratio because the items in it are all reported on the balance sheet.

It is also commonly referred to as a leverage ratio, which is any financial ratio that looks at how much capital comes in the form of debt, or the ability of a company to meet its financial obligations.

Also worth noting is that, unlike some financial ratios, the debt to equity ratio is not expressed as a percentage.

Debt to Equity Analysis

The benchmarks for debt to equity ratios are different depending on the industry. The reason for this is that some industries generally use more debt to finance the company than others.

Let’s say the company is a financial services provider. It’s likely they will have a higher debt to equity ratio because, in order to lend money, they need to also borrow it.

Capital intensive industries like finance and manufacturing will have a higher ratio and a lot of lenders will consider these to be higher risk businesses.

A lower debt to equity ratio value is considered favorable because it indicates a lower risk.

So if the debt ratio was 0.5 this shows that the company has half the liabilities than it has equity. Put simply, the company assets are funded 2:1 by investors vs creditors and investors own 66.6 cents of every dollar in assets to 33.3c owned by creditors.

Companies with a lower debt to equity ratio are often more financially stable and more attractive to both creditors and investors.

What about a negative value debt to equity ratio? Having a debt ratio of less than zero would be a cause for concern because it shows instability in the business and a negative return on investment – usually in the form of higher interest on the debts than the investment return.

Debt to Equity Ratio Example

Marvellous Marvin’s is a store selling high-end magic products to professional magicians. They have a $50,000 line of credit with the bank and a $465,000 mortgage on the store property.

The shareholders of Marvin’s have invested $1m into the company. Let’s calculate the debt to equity ratio.

First, we need to calculate the total liabilities:

Total\: Liabilities = \$50{,}000 + \$465{,}000 = \$515{,}000

Then we use the debt to equity ratio formula from earlier:

Debt\: to\: Equity = \dfrac{\$515{,}000}{\$1{,}000{,}000} = 0.515

A debt to equity ratio of 0.515 is well balanced and is a good sign that Marvin’s is running a stable business. They haven’t taken on too much debt relative to their equity and would be a more attractive option to lenders or investors than other similar stores with a higher D/E ratio.

Conclusion

When working with the debt to equity ratio and formula, the below points are worth bearing in mind as a quick recap of what it is, why it’s used, and how to use it:

  • Debt to equity ratio measures the total debt of the company (liabilities) against the total shareholders’ equity (equity).
  • The numbers needed to calculate the debt to equity ratio are found on the company’s balance sheet.
  • It is expressed as a number, not a percentage.
  • Some industries, like finance and manufacturing, have a higher ratio because they require a lot of capital.
  • A lower debt ratio is favorable and lower risk.
  • High debt to equity ratio would indicate a risk to lenders and investors.
  • A negative debt to equity ratio is also concerning as it shows instability and a negative return on investment

Debt to Equity Ratio Calculator

You can use the debt to equity ratio calculator below to work out your own ratios.