How to Calculate Debt to Equity Ratio

Debt to equity (D/E) is a financial ratio indicating the relationship between the outsiders funds (debts) and the shareholders funds (equity). This ratio plays an essential role in evaluating a company's capital structure and financial leverage, helping investors, creditors, and financial analysts understand how much of the company's financing comes from debt versus equity. By comparing the funds provided by external creditors (debt) to the funds contributed by shareholders (equity), the D/E ratio gives insights into a company's ability to meet its financial obligations, the level of risk it carries, and its overall financial health.

Interpreting the Debt to Equity Ratio

The Debt to Equity ratio offers valuable insights into a company's capital structure, and understanding the interpretation of this ratio can provide important implications for stakeholders.

A D/E Ratio of 1.0: A D/E ratio of 1.0 means that the company’s financing is equally split between debt and equity. In this case, the company has an equal amount of debt and equity financing. This is often considered a balanced or neutral capital structure, indicating that the company is using both equity and debt financing to fund its operations and growth. For example, if a company has $1 million in equity, it would have an equivalent $1 million in debt.

A D/E Ratio Greater than 1.0: A ratio greater than 1.0 indicates that the company has more debt than equity. For example, a ratio of 2.0 means that the company is financing itself with twice as much debt as equity. Companies with a high D/E ratio are generally considered to be more aggressive in their financing strategy, relying heavily on external borrowings to fund their operations, expansions, or investments. This can increase the risk, as the company must meet its debt obligations even if it doesn't generate enough revenue or cash flow.

A D/E Ratio Less than 1.0: A D/E ratio of less than 1.0 indicates that the company is primarily financed by equity rather than debt. This can suggest that the company is more conservative in its approach to financing and may be less vulnerable to the financial risks associated with high levels of debt. Companies with a low D/E ratio are typically seen as having a lower risk profile, as they have fewer debt obligations to meet.

Learn how to calculate Debt to Equity ratio with the following example:

EFL Company has the following data:
Common Equity $250,000
Long-Term Debt $500,000
Short-Term Debt $200,000
Preferred Equity $370,000
Retained Earnings $230,000
Additional Paid In Capital $70,000
Calculate the Debt to Equity Ratio.

Solution:
Total Debt = Short-Term Debt + Long-Term Debt = 200,000 + 500,000 = $700,000
Total Shareholders' Equity = Common Equity + Preferred Equity + Additional Paid In Capital + Retained Earnings = 250,000 + 370,000 + 70,000 + 230,000 = $920,000

D/E = Total Debt / Total Equity = 700,000 / 920,000 = 0.76 times