Debt to Equity Ratio: How It's Calculated and What It Measures

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One of the most important things on a firm’s balance sheet is the amount of debt they have on their balance sheet. Debt includes the firm's current liabilities which are the obligations the firm intends to pay off in one year or less. You will generally see current liabilities in accounts like accounts payable and accruals.

Debt also includes long-term debt. Long-term debt is debt that has a maturity of more than one year such as mortgages or long-term loans for other purposes.

If business owners see debt rising when they do trend analysis, that is a concern. Debt may be rising because the owners of a business may to want to contribute any more cash to the company, so they are considering acquiring more debt to address a shortfall, or perhaps to buy back shares. If they compare their balance sheet to the balance sheets of other firms in their industry and they see that they have higher debt, that is also a concern. Calculating the debt to equity ratio will help the owners know where they stand.

The debt to equity ratio is also closely monitored by lenders and creditors as it is a bellwether of the riskiness of a company's financial structure, providing early warning that a company may soon be unable to meet its payment obligations.

Calculating the Debt to Equity Ratio

The debt to equity ratio is calculated by dividing the firm’s total debt by the firm’s equity. Debt includes short-term debt (current liabilities on the balance sheet) and long-term debt.

Equity includes the combination of shareholder’s equity (the cash paid in by the investors when the company sold its stock) and the company’s retained earnings (the profit not paid out as dividends to the shareholders). The ratio ends up looking like this:

Debt/Equity = Total Debt/Shareholder’s Equity

Understanding the Debt to Equity Ratio

The result is the percentage that the company is in debt. In general, if the company is in debt more than 40-50%, the company needs to look at its financial statements more carefully and compare itself to other companies in the industry as it may be in financial difficulty.

If the company is a manufacturing company, however, the 40-50% debt to equity ratio may not be so bad. If the ratio has risen dramatically over time, then any company needs to take a closer look at its borrowing practices and why it has need for more debt financing.

Considerations

The debt to equity ratio can be misleading at times. An example is when the equity of a business contains a large proportion of preferred stock. In this case a dividend may be mandated in the terms of the stock agreement. This in turn impacts the amount of available cash flow to pay debt. Then the preferred stock has the characteristics of debt, rather than equity.

Another consideration is that the debt to equity ratio does not look at the imminence of debt repayment - whether the debt is due in the near term or the long term.

If long term, a high debt to equity ratio may not be so alarming.