Debt/Equity Ratio

A measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. It indicates what proportion of equity and debt the company is using to finance its assets.



Note: Sometimes only interest-bearing, long-term debt is used instead of total liabilities in the calculation.

Investopedia Says:
A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense.

If a lot of debt is used to finance increased operations (high debt to equity), the company could potentially generate more earnings than it would have without this outside financing. If this were to increase earnings by a greater amount than the debt cost (interest), then the shareholders benefit as more earnings are being spread among the same amount of shareholders. However, the cost of this debt financing may outweigh the return that the company generates on the debt through investment and business activities and become too much for the company to handle. This can lead to bankruptcy, which would leave shareholders with nothing.

The debt/equity ratio also depends on the industry in which the company operates. For example, capital-intensive industries such as auto manufacturing tend to have a debt/equity ratio above 2, while personal computer companies have a debt/equity of under 0.5.

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1. Total liabilities divided by total shareholders' equity. This shows to what extent owner's equity can cushion creditors' claims in the event of liquidation. Usually called Debt Ratio.

2. total long-term debt divided by total shareholders' equity. This is a measure of Leverage-the use of borrowed money to enhance the return on owners' equity.

3. long-term debt and preferred stock divided by common stock equity. This relates securities with fixed charges to those without fixed charges.

The relationship of these components of Purchase Capital. For example, if the outstanding Mortgage Amount is $75,000 and the equity is $25,000, the debt/equity ratio is 3:1. This is equivalent to a 75% Loan-To-Value Ratio loan. Similarly, if a corporation's debt is three times the amount of stock, the ratio is 3:1. If the debt/equity ratio of a corporation is too high, the IRS may classify the corporation as a Thin Corporation and disallow some of the interest expense, recasting the payment as a dividend to its shareholders.

Measure used in the analysis of financial statements to show the amount of protection available to creditors. The ratio equals total liabilities divided by total stockholders' equity; also called debt to net worth ratio. A high ratio usually indicates that the business has a lot of risk because it must meet principal and interest on its obligations. Potential creditors are reluctant to give financing to a company with a high debt position. However, the magnitude of debt depends on the type of business. For example, a bank has a high debt ratio but its assets are generally liquid. A utility can afford a higher ratio than a manufacturer because its earnings can be controlled by rate adjustments. Usually, book value is used to measure a firm's debt and equity securities in calculating the ratio. Market value may be a more realistic measure, however, because it takes into account current market conditions. See also Capital Structure.