The debt-to-equity ratio is a measure of the relationship between the capital contributed by creditors and the capital contributed by shareholders. It also shows the extent to which shareholders’ equity can fulfill a company’s obligations to creditors in the event of a liquidation .
Here is the debt-to-equity ratio formula:
Debt-to-Equity Ratio = Total Debt / Total Equity
Let’s look at an example. Here is some information about Company XYZ:
Using the debt-to-equity formula and the information above, we can calculate that Company XYZ’s debt-to-equity ratio is:
$15,000,000 / $10,000,000 = 1.5 times, or 150%
This means that for every dollar of Company XYZ owned by the shareholders, Company XYZ owes $1.50 to creditors.
It is important to note that there are many ways to calculate the debt-to-equity ratio, and therefore it is important to be clear about what types of debt and equity are being used when comparing debt-to-equity ratios.
For example, the analyst ‘s definition of debt may or may not include all short-term and long-term fixed obligations, including subordinated convertible debt, operating liabilities such as accounts payable and accrued liabilities and leases, contractual obligations or other forms of financing that may not appear on the balance sheet .
Additionally, some analysts may consider preferred stock as debt rather than equity in this calculation, and some analysts also argue that deferred taxes should be considered in the debt portion of the calculation because some forms of deferred taxes may never be paid and are thus part of a company’s capital base.
In general, a high debt-to-equity ratio indicates that a company may not be able to generate enough cash to satisfy its debt obligations. However, low debt-to-equity ratios may also indicate that a company is not taking advantage of the increased profits that financial leverage may bring.
Capital-intensive industries tend to have higher debt-to-equity ratios than low-capital industries because capital-intensive industries must purchase more property, plants and equipment to operate. This is why comparison of debt-to-equity ratios is generally most meaningful among companies within the same industry, and the definition of a “high” or “low” ratio should be made within this context.
Lenders and investors usually prefer low debt-to-equity ratios because their interests are better protected in the event of a business decline. Thus, firms with high debt-to-equity ratios may not be able to attract additional capital.