The debt-to-equity ratio shows how much of a company is owned by creditors (people it has borrowed money from) compared with how much shareholder equity is held by the company. It is one of three calculations used to measure debt capacity—along with the debt servicing ratio and the debt-to-total assets ratio.
Debt capacity shows both a company’s ability to service its current debt payments and its ability to raise cash through new debt, if necessary. This might include helping the company through a market downturn or helping the company take advantage of opportunities as they arise.
The debt-to-equity ratio is primarily used to evaluate a company’s ability to raise cash from new debt. That assessment is made by comparing the ratio to other companies in the same industry.
The higher a company’s debt-to-equity ratio, the more it is said to be leveraged. Highly leveraged companies carry more risk of missing debt payments when revenues decline. They are also less able to raise new debt.
More about the debt-to-equity ratio
The debt-to-equity ratio is calculated by dividing a company’s total debt by the total equity of its shareholders. In the sample balance sheet below, ABC Co.’s total debt is $200,000 and its total shareholder equity is $100,000, so its debt-to-equity ratio would be:
$200,000 / $100,000 = 2:1
This means two-thirds of ABC Co. is owned by creditors and one-third by shareholders. This is high compared with other companies in the same industry. It suggests ABC would have trouble incurring additional debt.