Business, Legal & Accounting Glossary
Debt-to-Equity Ratio is a measure of financial leverage, indicating what proportion of equity and debt a company is using to finance its assets. A high ratio implies that a company has been aggressive in financing its growth through debt and may be high risk for investors.
Debt to equity ratio is essentially a company’s total liabilities divided by its stockholders’ equity. It gives an indication of a company’s proportionate use of debt and equity for financing its assets.
There are various ways to compute the debt to equity ratio, because certain securities (like preferred stock) have characteristics of both debt and equity. But put simply, the debt to equity ratio is bonds divided by shareholder capital, which includes retained earnings.
The debt to equity ratio indicates how much protection the company’s creditors have: the lower the company’s debt to equity ratio, the bigger the financial cushion to pay bondholders. But a debt to equity ratio of zero may not be ideal. If the returns generated by new bonds outweigh the costs to service them, a company will often take on additional debt even though that will increase its debt to equity ratio. Thus a high debt to equity ratio can indicate a troubled business, but also an aggressive company eager for profits.
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, a low debt-to-equity ratio may also indicate that a company is not taking advantage of the increased profits that financial leverage may bring.
US companies have an average Debt-to-Equity Ratio of approximately 1.5. This is typical for other countries as well. The optimal Debt-to-Equity Ratio is considered to be about 1, i.e. liabilities = equity, but the ratio is industry-specific, depending on the proportion of current and non-current assets.
The more non-current the assets (as in the capital-intensive industries), the more equity is required to finance these long term investments. For most companies the maximum acceptable debt-to-equity ratio is 2, the exception being large public companies which may have a Debt-to-Equity Ratio higher than 2.
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This glossary post was last updated: 14th April, 2020 | 12 Views.