A company’s debt-to-equity ratio illustrates the mix of debt and equity a company uses to fund its growth and purchase assets. The debt-to-equity ratio represents a company’s financial leverage. A ratio that is higher than one indicates that a company uses mostly debt to finance their growth and assets and a ratio lower than one means that a company uses mostly equity. A common formula to use when calculating the debt-to-equity ratio is total liabilities divided by shareholder’s equity.
A debt-to-equity ratio gives investors a quick picture as to how much shareholder’s have invested in the company by purchasing the company’s stock and how much outside financing, such as business loans, the company uses. A company with a high debt-to-equity ratio uses a large portion of outside financing while a company with a low debt-to-equity ratio uses a small portion of outside financing. When calculating the debt-to-equity ratio, some companies opt to use only long and short-term debt in their calculations instead of total liabilities.
High Debt-to-Equity Example
Sun Bottling Inc., has $500 million in total liabilities and $100 million in shareholder’s equity. The calculation for the debt-to-equity ratio is $500 million / $100 million = 5. Sun Bottling is a highly leverage company, using mainly debt to finance its growth and assets. To investors, the company represents a high-risk investment because of it is carrying a high debt load and a large portion of the company’s revenue is going toward paying its debt obligations. However, it can also represent the possibility of higher returns because Sun Bottling may be using the outside financing to expand its operations to increase production, something the company may not have been able to do without outside financing. This can potentially increase revenue and investor returns.
Low Debt-to-Equity Example
Moon Enterprises has $10 million in total liabilities and $40 million in shareholder’s equity. The calculation for the debt-to-equity ratio is $10 million / $20 million = .25. Moon Bottling uses a larger amount of equity and a smaller amount of debt to finance its growth and assets. However, it is important for investors to discover how Moon Enterprises acquired the equity to finance its growth and assets to determine its investment risk. If the company issued additional shares to increase equity, the value of total outstanding shares becomes diluted and earnings per share decreases.
Using Debt Only Example
To calculate the debt-to-equity ratio, investors find the company’s financial information on its balance sheet. If an investor is using short and long-term debt only for her debt-to-equity ratio, she adds up the short-term and long-term debts listed on the balance sheet and then divides that number by shareholder’s equity. For example, a company’s total liabilities total $10 million with long and short-term debt at $8 million. Its shareholder’s equity is $15 million. Using the debt only, the equation is $8 million / $15 million = .53.
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