FinanceKPI / metricModelAccessible

Debt-to-equity (D/E) ratio

How should debt-to-equity (d/e) ratio be measured and interpreted?

AccessibleStrategicOrganisation2 min read

Contents

Helps managers answer: To what extent are we financing our business through debts versus equity?

A company can finance its operations with capital supplied by shareholders, with borrowed funds or with both. The debt-to-equity ratio compares those sources and shows how heavily the business relies on creditors relative to the equity supporting it.

When to use it

Answer the key performance question: “To what extent are we financing our business through debts versus equity?”
Assess this KPI within the Financial perspective.
Plan data collection, formula use, reporting frequency, and data-source requirements for this KPI.
Compare results against the targets, benchmarks, examples, or trend guidance available for this KPI.

Origins

Debt-to-equity is a conventional leverage ratio that developed with balance-sheet analysis and the growth of corporate debt markets. Early financial analysts used ratios to assess creditor protection and capital structure; later corporate-finance theory clarified the trade-off among tax benefits, financial flexibility and distress risk. There is no single canonical definition, so analysts must state how they treat leases, preferred shares, cash and non-interest-bearing liabilities.

What it is

Perspective: Financial perspective.

Key performance question: To what extent are we financing our business through debts versus equity?

A company with high debt relative to equity is highly leveraged or geared. Borrowing is not inherently harmful: if invested capital earns more than its interest and associated cost, leverage can increase returns beyond what shareholder capital alone could produce.

Excessive leverage, however, makes earnings more sensitive to interest expense and can constrain the company during a downturn. Creditors and shareholders may prefer a lower ratio because the equity cushion offers greater protection in liquidation. Yet an unusually low ratio can also show that management is not using affordable debt to finance valuable growth. The objective is a resilient capital structure, not the lowest possible number.

Capital intensity and normal financing practice differ by industry, so compare the ratio with companies that have similar assets, risk and accounting treatment.

How to use it

Measurement

Data collection method

Obtain the defined debt or liabilities and shareholder equity from the statement of financial position, then calculate the ratio consistently across periods and comparison companies.

Formula

A ratio above 1 means the selected measure of debt exceeds equity.

Definitions vary. Some analysts use total liabilities; others use only interest-bearing long-term debt. Book values are common, but market values may be appropriate when both debt and equity trade publicly. Name the chosen numerator and denominator beside the result.

Frequency

Calculate at least annually and consider a rolling quarterly view when leverage changes materially within the year.

Source of the data

Use the balance sheet or statement of financial position, supported by debt-note disclosures where classification matters.

Cost/effort in collecting the data

Collection effort is minimal because the underlying accounting figures are normally available.

Target setting/benchmarks

Set targets by industry, business risk, cash-flow stability and financing strategy. Sites such as http://ycharts.com and www.bizstats.com publish industry comparisons. Rules of thumb suggesting that ratios above 0.75% are dangerous or that 0.3% is desirable are too crude to apply without checking the formula and sector context.

Example

Consider the example adapted from www.investinganswers.com/term/debt-equity-ratio.htm.

Applying the selected formula to Company XYZ gives:

The result means that for each dollar of shareholder equity, Company XYZ owes $1.50 to creditors.

Top practical tip

Put the calculation definition next to the ratio. A comparison is meaningless when one company uses total liabilities and another uses only interest-bearing debt, or when one uses book equity and another uses market value.

Also reconcile unusual equity movements before interpreting the trend.

Top pitfall

Negative or distorted equity can make the ratio unusable. Western Union (NYSE: WU), after a debt-heavy separation from First Data (NYSE: FDC), had negative equity even though operating cash flow supported interest, debt reduction, buybacks and investment.

Share repurchases create another distortion because original shares enter equity at par value—often $0.01 to $1—while treasury stock is deducted at repurchase cost. Anheuser-Busch (NYSE: BUD) reported $8.2 billion of debt and $3.8 billion of equity, producing a D/E ratio of 217%. Its $15.3 billion of treasury shares explained much of the result; without those buybacks, the ratio fell to 43%.