What Is Debt-to-Equity (D/E) Ratio?
Debt-to-equity (D/E) ratio is used to evaluate a company’s financial leverage and is calculated by dividing a company’s total liabilities by its shareholder equity. D/E 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. Debt-to-equity ratio is a particular type of gearing ratio.
KEY TAKEAWAYS
- Debt-to-equity (D/E) ratio compares a company’s total liabilities with its shareholder equity and can be used to assess the extent of its reliance on debt.
- D/E ratios vary by industry and are best used to compare direct competitors or to measure change in the company’s reliance on debt over time.
- Among similar companies, a higher D/E ratio suggests more risk, while a particularly low one may indicate that a business is not taking advantage of debt financing to expand.
- Investors will often modify the D/E ratio to consider only long-term debt because it carries more risk than short-term obligations.
D/E Ratio Formula and Calculation
The information needed to calculate D/E ratio can be found on a listed company’s balance sheet. Subtracting the value of liabilities on the balance sheet from that of total assets shown there provides the figure for shareholder equity, which is a rearranged version of this balance sheet equation:
These balance sheet categories may include items that would not normally be considered debt or equity in the traditional sense of a loan or an asset. Because the ratio can be distorted by retained earnings or losses, intangible assets, and pension plan adjustments, further research is usually needed to understand to what extent a company relies on debt.
To get a clearer picture and facilitate comparisons, analysts and investors will often modify the D/E ratio. They also assess the D/E ratio in the context of short-term leverage ratios, profitability, and growth expectations.
How to Calculate D/E Ratio in Excel
Business owners use a variety of software to track D/E ratios and other financial metrics. Microsoft Excel provides a balance sheet template that automatically calculates financial ratios such as D/E ratio and debt ratio.1 Or you could enter the values for total liabilities and shareholders’ equity in adjacent spreadsheet cells, say B2 and B3, then add the formula “=B2/B3” in cell B4 to obtain the D/E ratio.
What Does D/E Ratio Tell You?
D/E 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 D/E 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 D/E 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.
For example, cash ratio evaluates a company’s near-term liquidity:
So does current ratio:
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