The Meaning of Debt-to-Equity
One of the fundamentals behind a business is its ability to pay back money borrowed for operating costs. A business that can leverage its borrowing power to increase production and therefore increase cash flow will have a strategic advantage over a business that cannot. One way to determine if a business is over leveraged is by examining its debt-to-equity ratio.
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Leverage Snapshot
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The debt-to-equity ratio provides a snapshot of a company's ability to borrow and repay money. It compares what a company owes (debt) to what it owns (equity). Because this ratio tells just how much the company is willing to operate with debt as opposed to equity, it is monitored carefully by both creditors and investors. Companies with very high debt-to-equity ratios can be at risk for defaulting on their obligations when facing an economic slowdown.
Formula
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The debt-to-equity formula is total liabilities divided by total equity. Sometimes a company will calculate only its long-term, interest-bearing debt in this equation. For accuracy, the company's total liabilities, including operating and capital lease payments, should be included. Operating expenses can include payroll, benefits and tax liabilities.
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Considerations
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For this formula to be truly useful, there are two key points to keep in mind. First, compare the results of one company to the results of its industry peers. If you are examining the debt-to-equity ratio of an automobile manufacturer, it would not make sense to compare it to a company that manufactures stethoscopes. Second, use this ratio over a period of several years, and do not neglect to consider the time line of repayment obligations. All these factors provide a more accurate picture of company solvency.
Personal Finances
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You also can use this ratio on a personal level. Similar to how you calculate your net worth (assets minus liabilities), you can divide your total debt (liabilities) by your assets (equity). This can give you a quick look at your financial well-being.
Other Ratios
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You should not pass judgment on a company solely on a single ratio such as debt-to-equity. Take into consideration other factors, such as its debt-to-capital ratio (debt the company owes divided by total capital plus debt the company is owed) and long-term debt-to-capitalization ratio (long-term debt divided by long-term debt plus preferred stock plus common stock). Analyzing all of these factors will give you a better understanding of how a company is using its ability to leverage debt and its long-term solvency outlook.
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References
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