What is Debt to Equity Ratio?
The Debt to Equity Ratio, or “D/E ratio”, measures a company’s financial risk by comparing its total outstanding debt obligations to the value of its shareholders’ equity account.
How to Calculate Debt to Equity Ratio (Step-by-Step)
The debt to equity ratio compares the total debt balance on a company’s balance sheet to the value of its total shareholders’ equity.
The D/E ratio represents the proportion of financing that came from creditors (debt) versus shareholders (equity).
- Debt → Comprised of short-term borrowings, long-term debt, and any debt-like items
- Shareholders’ Equity → Any equity contributed by the owners, equity raised in the capital markets, and retained earnings
In general, if a company’s D/E ratio is too high, that signals that the company is at risk of financial distress (i.e. at risk of being unable to meet required debt obligations).
However, a low D/E ratio is not necessarily a positive sign, as the company could be relying too much on equity financing, which is costlier than debt.
In addition, the reluctance to raise debt can cause the company to miss out on growth opportunities to fund expansion plans, as well as not benefit from the “tax shield” from interest expense.
Debt to Equity Ratio Formula (D/E)
The formula for calculating the debt to equity ratio is as follows.
For example, let’s say a company carries $200 million in debt and $100 million in shareholders’ equity per its balance sheet.
- Debt = $200 million
- Shareholders’ Equity = $100 million
Upon plugging those figures into our formula, the implied D/E ratio is 2.0x.
- D/E Ratio = $200 million / $100 million = 2.0x
Conceptually, the D/E ratio answers, “For each dollar of equity contributed, how much in debt financing is there?”
So, the debt to equity ratio of 2.0x indicates that our hypothetical company is financed with $2.00 of debt for each $1.00 of equity.
That said, if the D/E ratio is 1.0x, creditors and shareholders have an equal stake in the company’s assets, while a higher D/E ratio implies there is greater credit risk due to the higher relative reliance on debt.
What is a Good Debt to Equity Ratio?
Lenders and debt investors prefer lower D/E ratios as that implies there is less reliance on debt financing to fund operations – i.e. working capital requirements such as the purchase of inventory.
By contrast, higher D/E ratios imply the company’s operations depend more on debt capital – which means creditors have greater claims on the assets of the company in a liquidation scenario.
For lenders, the existing debt on the balance sheet causes the borrower to be riskier to work with, especially for risk-averse debt lenders – and for shareholders, more debt means there are more claims on the company’s assets with higher priority than that of the shareholders.
Lenders and investors perceive borrowers funded primarily with equity (e.g. owners’ equity, outside equity raised, retained earnings) more favorably.
Under a hypothetical liquidation, including for creditors placed lower in the capital structure behind senior lenders, full recovery is not guaranteed – therefore, pre-existing creditors holding substantial claims on the company’s assets (and liens) increase the risk to creditors of lower seniority and equity holders.