The debt to equity ratio is a financial, liquidity ratio that compares a company’s total debt to total equity. The debt to equity ratio shows the percentage of company financing that comes from creditors and investors. A higher debt to equity ratio indicates that more creditor financing (bank loans) is used than investor financing (shareholders). The debt to equity ratio is calculated by dividing total liabilities by total equity. The debt to equity ratio is considered a balance sheet ratio because all of the elements are reported on the balance sheet. AnalysisEach industry has different debt to equity ratio benchmarks, as some industries tend to use more debt financing than others. A debt ratio of .5 means that there are half as many liabilities than there is equity. In other words, the assets of the company are funded 2-to-1 by investors to creditors. This means that investors own 66.6 cents of every dollar of company assets while creditors only own 33.3 cents on the dollar. A debt to equity ratio of 1 would mean that investors and creditors have an equal stake in the business assets. A lower debt to equity ratio usually implies a more financially stable business. Companies with a higher debt to equity ratio are considered more risky to creditors and investors than companies with a lower ratio. Unlike equity financing, debt must be repaid to the lender. Since debt financing also requires debt servicing or regular interest payments, debt can be a far more expensive form of financing than equity financing. Companies leveraging large amounts of debt might not be able to make the payments. Creditors view a higher debt to equity ratio as risky because it shows that the investors haven’t funded the operations as much as creditors have. In other words, investors don’t have as much skin in the game as the creditors do. This could mean that investors don’t want to fund the business operations because the company isn’t performing well. Lack of performance might also be the reason why the company is seeking out extra debt financing. ExampleAssume a company has $100,000 of bank lines of credit and a $500,000 mortgage on its property. The shareholders of the company have invested $1.2 million. Here is how you calculate the debt to equity ratio. 
Definition of Debt to Equity RatioDebt to equity ratio shows the company’s capital structure and how much part of it was financed by Debt (Bank loans, Debentures, Bonds, etc.) compared to the investor’s or shareholder’s funds i.e. Equity. High Debt to equity ratio and high level of creditor financing in company operations. If a business cannot perform a high debt to equity ratio can lead to bankruptcy. However, in case of business wants to expand, debt financing can be helpful and easy. Interpretation of Debt to Equity RatioThis article will discuss the Interpretation of the Debt Equity Ratio. The debt to Equity ratio helps us understand the company’s financial leverage. It is part of the ratio analysis under the section on the leverage ratio. This ratio measures how much of the company’s operations are financed by debt compared to equity; it calculates the entire debt of the company against shareholders’ equity. The debt to equity ratio reflects the company’s capital structure and tells in case of shutdown whether the outstanding debt will be paid off through shareholders’ equity or not. Formula: The formula for interpretation of debt to equity ratio is: Debt To Equity Ratio = Total Debt / Total Equity Total Debt = Long Term Debt + Short Term Debt + Fixed Payments Total Equity = Total Shareholder’s Equity Examples of Interpretation of Debt to Equity Ratio(With Excel Template)Let’s take an example to understand the calculation in a better manner. Example #1The capital structure of ABC company is given below calculate the debt to equity ratio Solution: Total Debt is calculated using the formula given below Total Debt = Bank Loan + Account Payable + Bonds + Other Fixed Payments
Debt to Equity Ratio is calculated using the formula given below Debt to Equity Ratio = Total Debt / Total Equity
Debt to Equity ratio below 1 indicates a company is having lower leverage and lower risk of bankruptcy. But to understand the complete picture it is important for investors to make a comparison of peer companies and understand all financials of company ABC. Example #2The capital structure of XYZ company is given below calculate the debt to equity ratio Solution: Total Short Term Liabilities = Account Payables + Creditors + Accrued Expenses + Current Portion of Long Term Debt
Total Long Term Liabilities is calculated using the formula given below Total Long Term Liabilities = Bank Loan + Bonds
Total Debt is calculated using the formula given below Total Debt = Long Term Liabilities + Short Term Liabilities
Debt to Equity Ratio is calculated using the formula given below Debt to Equity Ratio = Total Debt / Total Equity
In this case, we have considered preferred equity as part of shareholders’ equity but, if we had considered it as part of the debt, there would be a substantial increase in debt to equity ratio. In this case, the company has a balanced debt to equity ratio, but investors need to understand the concept of debt. Example #3The following information on best buy co.inc company is given below to calculate the debt to equity ratio. Source Link: www.readyratios.com Solution: Debt to Equity Ratio is calculated using the formula given below Debt to Equity Ratio = Total Debt / Total Equity
Example #4The following information on Walmart inc. is given below to calculate the debt to equity ratio. Source Link: Walmart Inc. Balance Sheet Solution: Debt to Equity Ratio is calculated using the formula given below Debt to Equity Ratio = Total Debt / Total Equity
For example, 3 and 4 if we compare both the company’s debt to equity ratio Walmart looks much attractive because of less debt. However, after doing research from all aspects investor can decide which company to invest. Importance of Debt to Equity RatioSome of the Importance is given below: 1. Financial AnalysisDuring the process of financial analysis of the company, it is important for an investor to understand the debt structure of a company, which tells us how much the is company dependent on borrowers and its capacity to pay off debt if the business is facing a hard time. 2. Capital StructureThe capital structure of the company is described by Debt to Equity ratio, it specifically tells how much part of the capital in business is financed from borrowed funds and how much part is financed from owned funds i.e. Shareholders equity. It helps investors understand the capacity of the company to pay out the company’s debt and determine the risk of the amount invested in the company. 3. Risk AnalysisDebt to Equity ratio is also known as risk ratio and gearing ratio which defines how much bankruptcy risk a company is taking in the market. A high debt to equity ratio means a higher risk of bankruptcy in case business is not able to perform as expected, while a high debt payment obligation is still in there. 4. Shareholder’s EarningsThe debt to equity ratio also describes how much shareholders earn as part of the profit. High debt to equity ratio means, profit will be reduced, which means less dividend payment to shareholders because a large part of the profit will be paid as interest and fixed payment on borrowed funds. 5. TrustworthinessWhen a business applies for loan lenders check the ability of a business to pay off its debt, this credit trustworthiness can be tested through Debt to equity ratio by checking past records and regular installment payments made by the company to its lenders. 6. Tool for ManagementThe debt to equity ratio tells management where the business stands in comparison to peers. The ideal debt to equity ratio will help management to make expansion decisions for further growth of business and increase its share in the market by adding more units or operations. Limitations of Interpretation of Debt to Equity RatioSome of the Limitations of Interpretation of Debt to Equity Ratio are: 1. Can Misguide InvestorsIt is important for an investor to analyze the company from all angles and understand all ratios since the single ratio can be misguided like in this case debt to equity ratio can misguide investors. Lower debt to equity ratio can be the result of technical insufficiency, where the company is not able to handle debt through properly investing in assets required which can lead to lower returns on investment even with lower debt to equity ratio. 2. An Ideal Ratio is Not Applicable to All IndustriesIdeal debt to equity ratio of 1:1 is not applicable to all companies. Some companies may require high debt to purchase, update and maintain their assets through debt financing, which will help a business to grow and gain more profit in the future. While in the case of business in the IT industry does not require high capital for factory and machinery, which help them to maintain better debt to equity ratio. 3. Requires Clear UnderstandingInvestor needs a clear understanding of the concept of debt while understanding and analyzing the debt to equity ratio of the company. Some business considers prefer stock as equity but, dividend payment on preferred stocks is like debt. If a company includes preferring stock in debt then the total debt will increase significantly, which means the company will look a lot more risky to an investor. It is important to understand the concept of debt working in that specific industry. ConclusionThe debt to equity ratio helps investors to understand the risk involved in business while making an investment decision. High leverage company has a higher risk of bankruptcy in case business is not able to perform as expected, on the other side debt helps businesses to expand and grow in operations which results in more profit for the future. To understand the risk involved in investment investors must not depend on only a single ratio but should make the entire 360-degree analysis of the company, which will give him a clear picture of company financials. An investor can make comparisons with peer companies in case of debt to equity ratio to understand requirements average capital structure for companies operating in a specific sector. Recommended ArticlesThis is a guide to the Interpretation of Debt to Equity Ratio. Here we discuss how to calculate debt to equity ratio along with practical examples. we also provide a downloadable excel template. You may also look at the following articles to learn more –
What does it mean if debtA ratio less than 1 implies that the assets are financed mainly through equity. A lower debt to equity ratio means the company primarily relies on wholly-owned funds to leverage its finances.
Is a 0.3 debtIn general, many investors look for a company to have a debt ratio between 0.3 and 0.6. From a pure risk perspective, debt ratios of 0.4 or lower are considered better, while a debt ratio of 0.6 or higher makes it more difficult to borrow money.
What does a debtA ratio of 0.5 means that you have $0.50 of debt for every $1.00 in equity. A ratio above 1.0 indicates more debt than equity.
Is a 0.25 debtDebt ratio = total farm liabilities / total farm assets. This indicates the number of dollars of debt for every dollar of asset value. Generally a ratio of less than 0.25 is considered very strong, a 0.25 to 0.40 ratio is satisfactory and more than 0.40 is weak.
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Debt to equity ratio less than 1
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