A long-term debt-to-equity ratio is a measure investors and lenders use to assess the risk a company presents. The long-term debt ratio is the portion of a firm’s capital that comes from borrowing for more than one year, expressed as a proportion of shareholders’ equity. A high ratio means more debt and thus more risk. Excessive long-term debt can indicate a firm is unable to generate enough capital from profits or selling stock to meet investment needs. Too much debt, both short-term and long-term, means a firm is less likely to be able to meet its debt obligations. Should the company become insolvent, there is less chance that selling off assets will raise enough cash to pay the debt.
Calculating the Ratio
The formula for long-term debt-to-equity is long-term debt divided by the total of common stock equity and preferred stock equity. Suppose a company has $8 million in long-term debt. Common stock equity on the balance sheet equals $5 million and there is another $1.4 million in preferred stock. Total stockholders’ equity equals $6.4 million. Divide $8 million by $6.4 million and you get a long-term debt-to-equity ratio of 1.25.
Variations of the Ratio
There is more than one way to figure a debt-to-equity ratio. One alternative is total debt to total equity. In this variation, short-term debt is added to long-term debt and the total is divided by total stockholder’s equity. Another version is long-term debt to common stock equity. Using this approach, preferred stock is treated as a long-term debt and added to other debt obligations. The total is divided by the value of common stock to calculate the debt-to-equity ratio.