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Debt-to-Equity Ratio: Definition, Formula and Interpretation

DEFINITION:

The Debt-to-Equity ratio or D/E ratio (in Finnish, velkaantumisaste) measures a company's financial leverage. This ratio is also called the “Gearing ratio",” Risk ratio” or “Leverage ratio”. The ratio shows the percentage of company financing by its creditors (banks) and investors (shareholders). It measures the ability of company to repay its obligations.

FORMULA for calculations:

\[ {D/E\ ratio} = {Total\ Debt \over Equity} \]
\[ {D/E\ ratio} = {Total\ Liabilities \over Total\ Stockholders\ Equity} \]

\[ {D/E\ ratio} = {(ST\ Debt\ +\ LT\ Debt\ +\ FP\ Obligations) \over Total\ Stockholders\ Equity} \]

WHERE:

  • ST Debt: Short-Term Debt
  • LT Debt: Long-Term Debt
  • FP Obligations: Fixed Payment Obligations

RESULT INTERPRETATION:

A higher debt-equity ratio indicates more leveraged company and, as a result, riskier business to investors. While a lower ratio indicates the business is less leveraged and closer to being fully financed by their own capital. Thus, the lower the value of the ratio, the better.

Nevertheless, it should be noted that the ratio varies by industry, some industries use more debt financing than others. It is quite normal for the company with stable financial situation, which generate a significant cash flow to have a higher debt-equity ratio. Whereas, this is not desirable for the company in decline.

If debt-equity ratio is increasing it indicates that company uses more debt. As a result, the company's return on equity ROE% can increase. It happens because the equity account is smaller as we using debt instead of equity. Thus, it's crucial to be cautious when investing in companies with high ROE %.

EXAMPLE:

Let's suppose, Business' Debt-to-Equity ratio is 0,25, which means that for every euro in equity the company has 25 cents in leverage.

Example of "Net Gearing ratio" calculation

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