Debt to Equity Ratio

The debt-to-equity ratio is a financial ratio indicating the relative proportion of equity and debt used to finance a company’s assets. This ratio is also known as Risk, Gearing or Leverage. It is equal to total debt divided by shareholders’ equity. The two components are often taken from the firm’s balance sheet or statement of financial position (so-called book value), but the ratio may also be calculated using market values for both, if the company’s debt and equity are publicly traded, or using a combination of book value for debt and market value for equity.

Typically when you decide to invest into a company, the higher the ratio the riskier it could be especially if the interest rates are rising. If you are finding that your solution to this equation is greater 50%, then the numbers should be looked at very carefully to make sure there are no liquidity issues.

A higher ratio shows investors and lenders that there is increased risk that this company may default on a debt that is owed.

The result you get after dividing debt by equity is the percentage of the company that is indebted (or “leveraged”). The normal level of debt to equity has changed over time, and depends on both economic factors and society’s general feeling towards credit. Generally, any company that has a debt to equity ratio of over 40 to 50% should be looked at more carefully to make sure there are no liquidity problems. If you find the company’s working capital, and current / quick ratios drastically low, this is is a sign of serious financial weakness.

While companies may have other types of liabilities, such as those listed in an accounts payable ledger, these may or may not be counted as liabilities for the purposes of calculating a debt/equity ratio. In many cases, because they change so often, it may not provide a truly accurate account of liabilities for a company. Therefore, whether they are used is purely a subjective decision made by the company.

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