Debt-Equity Ratio

The Debt/Equity Ratio

The Debt/Equity Ratio is a ratio of ordinary shareholders’ equity and the stake of creditors in a company. In other words, it is a measure of a company’s financial leverage.

Debt/equity ratio is calculated as long-term debt divided by common shareholders’ equity. Typically, the data from the prior fiscal year is used in the calculation. If the ratio is greater than 1, it implies that majority of the company’s assets are financed through debt. On the other hand, if the ratio is less than 1, assets are primarily financed through equity.

A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense. If a company applies a lot of debt to finance increased operations (high debt to equity), it could generate more earnings than it would ordinarily have without this outside financing. If it is such that the earnings increase by a greater amount than the cost of debt (interest), then the shareholders will benefit as more earnings are being spread among the same number of shareholders. The flip side however is the situation where the cost of debt financing outweighs the return that the company generates on the debt through investment and business activities. It may therefore become too much for the company to handle. This can lead to bankruptcy, which would leave shareholders with nothing.

The debt/equity ratio also depends on the industry in which the company operates. For example, capital-intensive industries such as automobile manufacturers tend to have a high debt/equity ratio, while those not so capital intensive such as personal computer companies usually have a low ratio.