Debt to equity ratio

What is the Debt to Equity Ratio?

The debt to equity ratio measures the riskiness of a company's financial structure by comparing its total debt to its total equity. The ratio reveals the relative proportions of debt and equity financing that a business employs. It is closely monitored by lenders and creditors, since it can provide early warning that an organization is so overwhelmed by debt that it is unable to meet its payment obligations. This is also a funding issue. For example, the owners of a business may not want to contribute any more cash to the company, so they acquire more debt to address the cash shortfall. Or, a company may use debt to buy back shares, thereby increasing the return on investment to the remaining shareholders.

Whatever the reason for debt usage, the outcome can be catastrophic if corporate cash flows are not sufficient to make ongoing debt payments. This is a concern to lenders, whose loans may not be paid back. Suppliers are concerned about the ratio for the same reason. A lender can protect its interests by imposing collateral requirements or restrictive covenants; suppliers usually offer credit with less restrictive terms, and so can suffer more if a company is unable to meet its payment obligations to them.

When a business has a high debt to equity ratio, it has imposed on itself a large block of fixed cost in the form of interest expense, which increases its breakeven point. This situation means that it takes more sales for the firm to earn a profit, so that its earnings will be more volatile than would have been the case without the debt.

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How to Calculate the Debt to Equity Ratio

To calculate the debt to equity ratio, simply divide total debt by total equity. In this calculation, the debt figure should include the residual obligation amount of all leases. The formula is as follows:

(Long-term debt + Short-term debt + Leases) ÷ Equity = Debt to equity ratio

Other obligations to include in the debt part of this calculation are notes payable, bonds payable, and the drawn-down portion of a line of credit. A variation is to add all fixed payment obligations to the numerator of the calculation, on the grounds that these payments are akin to debt. For example, the remaining rent payments due on a lease could be included in the numerator. The numerator does not include accounts payable, accrued expenses, dividends payable, or deferred revenues.

Alternatives to the Debt to Equity Ratio

While the debt to equity ratio is useful for measuring the riskiness of an entity’s financial structure, it provides no insights into the ability of a business to repay its immediate debts. For that information, it is more useful to calculate a firm’s current ratio, which compares current assets to current liabilities. A variation is the quick ratio, which excludes inventory from current assets. Thus, it makes sense to combine the calculation of the debt to equity ratio with additional analyses that are used to examine liquidity over the short term.

Example of the Debt to Equity Ratio

As an example of the debt to equity ratio, New Centurion Corporation has accumulated a significant amount of debt while acquiring several competing providers of Latin text translations. New Centurion's existing debt covenants stipulate that it cannot go beyond a debt to equity ratio of 2:1. Its latest planned acquisition will cost $10 million. New Centurion's current level of equity is $50 million, and its current level of debt is $91 million. Given this information, the proposed acquisition will result in the following debt to equity ratio:

($91 Million existing debt + $10 Million proposed debt) ÷ $50 Million equity

=  2.02:1 Debt to equity ratio

The ratio exceeds the existing covenant, so New Centurion cannot use this form of financing to complete the proposed acquisition. However, it could attempt to alter the terms of the deal to drop the projected ratio below the 2:1 level.

Problems with the Debt to Equity Ratio

Though quite useful, the debt to equity ratio can be misleading in some situations. For example, if the equity of a business includes a large proportion of preferred stock, a significant dividend may be mandated under the terms of the stock agreement, which impacts the amount of residual cash flow available to pay debt. In this case, the preferred stock has characteristics of debt, rather than equity.

Another issue is that the ratio by itself does not state the imminence of debt repayment. It could be in the near future, or so far off that it is not a consideration. In the latter case, a high debt to equity ratio may be less of a concern.

What is a Good Debt to Equity Ratio?

Generally, a debt to equity ratio of no high than 1.0 is considered to be reasonable. However, what constitutes a good debt to equity ratio depends on a number of factors. For example, if a company has a history of consistent cash flows, then it can probably sustain a much higher ratio, since it can depend on having enough cash to make the related debt payments. Conversely, a new business without a firm business plan might not want to take on any debt at all, since it may not be in a position to pay it off.

Businesses located in industries where sales are reasonably assured (such as an electricity provider) will probably have such consistent cash flows that they can afford to maintain a fairly high debt to equity ratio. Conversely, a business located in a highly competitive market where product cycles are short would be well advised to maintain a very low debt to equity ratio, since its cash flows are so uncertain.

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