Treasury Practice

Debt to equity ratio

Published: Feb 2009

The debt to equity ratio is used to determine the relative proportion of equity and debt used to finance a company. This ratio is particularly useful in assessing the strength of a company’s balance sheet.

The debt to equity ratio is calculated as follows:

\(\mathrm{Debt\: to\: equity\: ratio}=\frac{debt}{equity}\)
For example, if a company has RMB 80m in debt and has equity totalling RMB 200m, its debt to equity ratio would be 80/200 or 0.40. The result is often multiplied by 100 to get a percentage, which in this case would be 40%. This is the percentage of the company that is leveraged (financed by debt). A higher number indicates that a greater proportion of debt is employed by the company.

What does it include?

When using the debt to equity ratio, all the shareholders’ equity – both invested capital and retained earnings – must be included as equity.

Debt should include:

  • All interest-bearing liabilities on the balance sheet, such as capital leases.
  • Off-balance sheet liabilities, such as operating leases and pensions.

It is possible, however, to use only interest-bearing, long-term debt in an amended version of the ratio to give a purely long-term view of the company’s financing.

What does it mean?

If a company is highly leveraged, this means that it is largely financed by debt. If a company is not highly leveraged, it is largely financed by equity. A company will normally benefit from having a certain amount of debt, as this can be used to fund investments that give a return which is greater than the cost of the debt. This gives an additional return to the shareholders and is described as leveraging their equity investment.

However, the more debt used to finance a company, the greater the risk to the shareholders if the company experiences any volatility in earnings. Providers of debt have to be paid interest. Shareholders are always the last to receive any money from a company in which they have invested, so a highly leveraged company would have to pay interest to all of its creditors before the shareholders saw a return on their investment. Lenders also expect their loans to be repaid or refinanced over time.

What represents a healthy debt to equity ratio varies from one company to another and there are many pages of academic research on the subject. Essentially the more stable and reliable a company’s earnings are, the more appropriate a higher level of debt is. It is also highly dependent on a number of other factors; not least the social and economic climate of the time and how the company and its industrial sector are regarded by lenders, analysts and investors.

Why use it?

The debt to equity ratio has a number of applications. A company can use its debt to equity ratio to help determine whether it is highly leveraged compared to its competitors, thereby using their situations to reflect on its own. It is also advisable to measure a debt to equity ratio over several years to identify trends over time rather than just a snapshot of the company’s financial status. Continued use of the debt to equity ratio at regular intervals over a number of years may also be useful to help detect signs of any emerging debt problems.

However, the debt to equity ratio should not be used as the sole indicator of a company’s dependence on debt financing. There are many other ratios, such as the debt ratio (total debt/total assets) and current ratio (current assets/current liabilities), which can be used in tandem with the debt to equity ratio to provide a more comprehensive view of a company’s leverage.

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