Investors commonly use the debt-to-equity ratio when evaluating a company because it offers insight to a company's primary funding sources. This ratio represents the amount of outstanding debt from creditors divided by the equity gained by shareholders purchasing stock. A high debt-to-equity ratio may indicate an over-dependence on debt, which could negatively effect earnings. A low ratio means the company depends primarily on shareholder equity.
1. Consult the company's balance sheet and get the outstanding debt and the shareholder equity.
2. Divide the debt by the equity to calculate the ratio. As an example, if a company has $3 million in debt with $4 million in shareholder equity, then the debt-to-equity is 0.75.
3. Compare this ratio to 1. A debt-to-equity ratio greater than 1 means the company relies more heavily on debt to run the business. A ratio less than 1 means the company primarily relies on equity for financing.
- Comstock Images/Stockbyte/Getty Images