Debt to Equity Ratio

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Measuring Solvency and Capital Structure. Explanation of Debt to Equity Ratio.

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The Debt to Equity Ratio is used for Measuring Solvency and researching the Capital Structure of a company. It indicates how much the company is leveraged (in debt) by comparing what is owed to what is owned. In other words it measures a company's ability to borrow and repay money.


Usage of the Debt to Equity Ratio by creditors and investors

The Debt to Equity Ratio is closely watched by creditors and investors, because it reveals the extent to which company management is willing to fund its operations with debt, rather than using equity.

 

For investors, a high Debt / Equity ratio or a higher one than the company's peers means:

  • Higher debt burden
  • Higher interest charges
  • Lower, uncertain earnings

Lenders such as banks are particularly sensitive about this ratio, since an excessively high ratio of debt to equity will put their loans at risk of not being repaid.

 

Possible actions by banks to counteract this problem are the use of restrictive contracts that force to use excess cash flow for debt repayment. Restrictions on alternative use of cash are also quite common, as well as a requirement for investors to put more equity into the company themselves.


Debt to Equity Ratio calculation

The Debt to Equity Ratio formula is fairly simple:


Divide Total Debt (= Total Liabilities) by Total Equity. Can be multiplied with 100 to get a percentage.

Note that the Debt figure should include all operating and capital lease payments.


Sometimes only long-term debt is taken into account in the numerator to look at the long term Debt to Equity capital structure.


Debt to Equity ratio benchmarking

Comparing the result with other companies in the same industry may prove useful. It is recommended to use the Debt to Equity Ratio over a period of several years and additionally take into account WHEN certain repayments are due as this can make a major difference for the solvency of the company.


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