The debt-to-equity ratio is one of the leverage ratios. It lets you peer into how, and how extensively, a company uses debt. The debt-to-equity ratio is simple and straight forward with the numbers coming from the balance sheet. The debt-to-equity ratio tells us how much debt the company has for every dollar of shareholders’ equity. This ratio is a banker’s ratio. A bank will compare your debt-to-equity ratio to others in your industry to see if you are loan worthy. A high ratio here means you are high risk. A low ratio means that you might be at risk for a take over. What is considered high and low is very different based on the industry you compete in.
Some in the finance industry will just use interest bearing debt rather than total liabilities in this ratio.
Using the balance sheet, the debt-to-equity ratio is calculated by dividing total liabilities by shareholders’ equity:
For example if a company’s total liabilities are $3,000 and its shareholders’ equity is $2,500, then the debt-to-equity ratio is 1.2. (Note: This ratio is not expressed in percentage terms.)
(Excerpts from Financial Intelligence, Chapter 22 – Leverage Ratios)
What’s a good debt-to-equity ratio? As with most ratios, the answer depends on the industry. But many, many companies have a debt-to-equity ratio considerably larger than 1 – that is, they have more debt than equity. Since the interest on debt is deductible from a company’s taxable income, many companies use debt to finance at least a part of their business. In fact, companies with particularly low debt-to-equity ratios may be targets for a leveraged buyout, in which management or other investors use debt to buy up the stock.
Bankers love the debt-to-equity ratio. They use it to determine whether or not to offer a company a loan. They know from experience what a reasonable debt-to-equity ratio is for a company of a given size in a particular industry (and, of course, they check out profitability, cash flow, and other measures as well).
From the HBR Blog:
What is the debt-to-equity ratio?
“It’s a simple measure of how much debt you use to run your business,” explains [Joe] Knight. The ratio tells you, for every dollar you have of equity, how much debt you have. It’s one of a set of ratios called “leverage ratios” that “let you see how —and how extensively—a company uses debt,” he says.” From A Refresher on Debt-to-Equity Ratio