The Debt-to-Equity Ratio Effect on Return on Equity

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Investors calculate a multinational company's return on equity (ROE) to determine how the corporation is growing its foreign business and navigating the doldrums of the global economy. Financiers also compute other metrics, including debt-to-equity ratio, to evaluate the organization's commercial footprint in local markets. ROE is a profitability indicator, whereas debt-to-equity ratio is a safety ratio.

Debt-to-Equity Ratio

Debt-to-equity ratio equals a company’s total liabilities divided by its equity capital, or net worth. As a safety metric, debt-to-equity ratio illustrates steps that corporate management is taking to reduce the organization’s reliance on debt, signaling whether the steps are effective. Equity holders, or shareholders, heed this indicator to determine how much money a company borrows to acquire long-term assets and whether the business has the financial strength to repay liabilities on time. Besides debt-to-equity ratio, investors closely watch such safety indicators as “cash flow to current maturity of long-term debt” and EBIT-to-interest. EBIT stands for earnings before interest and taxes.

Return on Equity

Return on equity is also known as return on investment (ROI). A key profitability ratio, ROE equals net profit before taxes divided by net worth. Generally speaking, ROI tells corporate managers whether their strategies are the appropriate ones, whether personnel are carrying out operational work according to plan, which tactics merit further review and tweaking, and the methodologies that might prop up revenues. Income growth is central in ROI management, because net profit -- which is integral to the ROI formula -- arises when revenues exceed expenses. Other profitability ratios include net profit margin, return on assets and gross profit margin.

Effect

Debt-to-equity ratio and ROI interrelate, although both concepts are distinct. Mathematically, both concepts have closely related formulas and fractions that share “equity” as a common denominator. Financially speaking, debt-to-equity may have a positive effect on ROI, assuming the shareholders’ equity amount stays intact. This is because the ROI -- which, in essence, is pre-interest income-to-equity ratio -- does not factor in interest remittances. So a corporate borrower may use loan proceeds to boost productivity and increase sales -- a situation that, in turn, would cause an increase operating income and revenue before taxes. Consequently, a high debt-to-equity ratio would result in a higher ROI number.

Operational Significance

The whole conversation about debt-to-equity ratio and ROI -- and financial ratios, in general -- relates to the tools and metrics a company uses to outgrow domestic rivals and keep foreign peers in competitive check. By periodically calculating profitability and safety ratios, the business can find effective ways to make more money, run efficient operations, and determine why some sector players are posting startling numbers while others are languishing behind the competitive pack.

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