The debt to equity ratio measures the riskiness of a company's financial structure by comparing its total debt to its total equity. The ratio reveals the relative proportions of debt and equity financing that a business employs. It is closely monitored by lenders and creditors, since it can provide early warning that an organization is so overwhelmed by debt that it is unable to meet its payment obligations. This is also a funding issue. For example, the owners of a business may not want to contribute any more cash to the company, so they acquire more debt to address the cash shortfall. Or, a company may use debt to buy back shares, thereby increasing the return on investment to the remaining shareholders.
Whatever the reason for debt usage, the outcome can be catastrophic if corporate cash flows are not sufficient to make ongoing debt payments. This is a concern to lenders, whose loans may not be paid back. Suppliers are concerned about the ratio for the same reason. A lender can protect its interests by imposing collateral requirements or restrictive covenants; suppliers usually offer credit with less restrictive terms, and so can suffer more if a company is unable to meet its payment obligations to them.
When a business has a high debt to equity ratio, it has imposed on itself a large block of fixed cost in the form of interest expense, which increases its breakeven point. This situation means that it takes more sales for the firm to earn a profit, so that its earnings will be more volatile than would have been the case without the debt.
How to Calculate the Debt to Equity Ratio
To calculate the debt to equity ratio, simply divide total debt by total equity. In this calculation, the debt figure should include the residual obligation amount of all leases. The formula is:
(Long-term debt + Short-term debt + Leases) ÷ Equity
Example of the Debt to Equity Ratio
For example, New Centurion Corporation has accumulated a significant amount of debt while acquiring several competing providers of Latin text translations. New Centurion's existing debt covenants stipulate that it cannot go beyond a debt to equity ratio of 2:1. Its latest planned acquisition will cost $10 million. New Centurion's current level of equity is $50 million, and its current level of debt is $91 million. Given this information, the proposed acquisition will result in the following debt to equity ratio:
($91 Million existing debt + $10 Million proposed debt) ÷ $50 Million equity
= 2.02:1 debt to equity ratio
The ratio exceeds the existing covenant, so New Centurion cannot use this form of financing to complete the proposed acquisition.
Issues with the Debt to Equity Ratio
Though quite useful, the ratio can be misleading in some situations. For example, if the equity of a business includes a large proportion of preferred stock, a significant dividend may be mandated under the terms of the stock agreement, which impacts the amount of residual cash flow available to pay debt. In this case, the preferred stock has characteristics of debt, rather than equity.
Another issue is that the ratio by itself does not state the imminence of debt repayment. It could be in the near future, or so far off that it is not a consideration. In the latter case, a high debt to equity ratio may be less of a concern.