What is Debt-to-Equity Ratio?
A company’s debt-to-equity ratio, or D/E ratio, is a measure of the extent to which a company can cover its debt. It is calculated by dividing a company’s total debt by its total shareholders’ equity. The higher the D/E ratio, the more difficult it may be for the business to cover all of its liabilities.
For example: $200,000 in debt/ $100,000 in shareholders’ equity = 2 D/E ratio
A D/E can also be expressed as a percentage. In this example, a D/E of 2 also equals 200%. This means that for every $1 of the company owned by shareholders, the business owes $2 to creditors.
Since there are many ways to calculate the D/E ratio, it’s important to be clear about exactly which types of debt and equity are included in the calculation.
Types of Debt
A D/E ratio can include some or all of the following types of debt:
- Short-term liabilities
- Long-term liabilities
- Accounts payable
- Accrued liabilities
- Leases and other financing arrangements
What a D/E Means
A high D/E ratio generally means that in the case of a business downturn, a company could have difficulty paying off its debts. The higher the D/E, the riskier the business.
However, there are industries where a high D/E ratio is typical, such as in capital-intensive businesses that routinely invest in property, plant, and equipment as part of their operations. On the other hand, lifestyle or service businesses without a need for heavy machinery and workspace will more likely have a low D/E.
While lenders and investors generally prefer that a company maintain a low D/E ratio, a low D/E can also suggest that the company may not be leveraging its assets well, limiting its profitability.