What to Do
The debt-to-equity ratio is found by dividing debt by equity, usually that stated in the preceding calendar or fiscal year, while debt can be either long-term debt only, or total liabilities.
The usual formula for the ratio is total debt divided by equity. So if total debt is $12,000,000 and equity $9,000,000, the debt-to-equity ratio is calculated as follows:
Alternative formulas include one involving only long-term debt and another which is the reciprocal of the debt-to-equity ratio: equity divided by total funds. However, the latter would more accurately be called an equity-to-debt ratio.
What You Need to Know
- A ratio greater than 1 means assets are financed mainly with debt, while a ratio of less than 1 means equity is the main source of most of the financing. A high ratio usually suggests that a company has financed growth aggressively with debt, with the result that earnings could be volatile owing to the cost of servicing the debt.
- It is essential that the definition of debt in the ratio presented is understood.
- When calculating the ratio, some people prefer to use the market value of debt and equity rather than the book value, since book value often understates current value. In this case, a low ratio suggests better financial stability than a high one. A high ratio means that a company could be at risk, especially if interest rates are rising.
- The ratio can be compared with those of other companies in a specific sector and over a period.
Where to Learn More
Web Site:
Investopedia: www.investopedia.com/terms/d/debtequityratio.asp
