Debt-to-equity (D/E) ratio is used to evaluate a company’s financial leverage and is calculated by dividing a company’s total liabilities by its shareholder equity. D/E ratio is an important metric in corporate finance. It is a measure of the degree to which a company is financing its operations with debt rather than its own resources. Debt-to-equity ratio is a particular type of gearing ratio.
D/E Ratio Formula and Calculation
Debt/Equity = Total Liabilities / Total Shareholders’ Equity
The information needed to calculate D/E ratio can be found on a listed company’s balance sheet. Subtracting the value of liabilities on the balance sheet from that of total assets shown there provides the figure for shareholder equity, which is a rearranged version of this balance sheet equation:
Assets = Liabilities + Shareholder Equity
These balance sheet categories may include items that would not normally be considered debt or equity in the traditional sense of a loan or an asset. Because the ratio can be distorted by retained earnings or losses, intangible assets, and pension plan adjustments, further research is usually needed to understand to what extent a company relies on debt.
Not all debt is equally risky. The long-term D/E ratio focuses on riskier long-term debt by using its value instead of that of total liabilities in the numerator of the standard formula:
Long-term D/E ratio = Long-term debt / Shareholder equity
Short-term debt also increases a company’s leverage, of course, but because these liabilities must be paid in a year or less, they aren’t as risky. For example, imagine a company with $1 million in short-term payables (wages, accounts payable, notes, etc.) and $500,000 in long-term debt, compared with a company with $500,000 in short-term payables and $1 million in long-term debt. If both companies have $1.5 million in shareholder equity, then they both have a D/E ratio of 1. On the surface, the risk from leverage is identical, but in reality, the second company is riskier.
As a rule, short-term debt tends to be cheaper than long-term debt and is less sensitive to shifts in interest rates, meaning that the second company’s interest expense and cost of capital are likely higher. If interest rates are higher when the long-term debt comes due and needs to be refinanced, then interest expense will rise.
Source: Investopedia, Debt-to-Equity (D/E) Ratio Formula and How to Interpret It, accessed 25 December 2023, <https://www.investopedia.com/terms/d/debtequityratio.asp>
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