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What is the debt-to-equity ratio?
The debt-to-equity ratio is the relationship between a company’s total debt and its total equity. The debt-to-equity ratio is a key measure for investors looking to a company’s financial health.
To understand the capital structure of a business, investors look at the company’s balance sheet. It lists the company’s assets, liabilities and equity. The debt-to-equity ratio is a function of a company’s liabilities, or what it owes on unpaid debts, and equity, or the value of its assets minus its liabilities. The ratio can be expressed with the formula: Total Liabilities / Total Shareholder Equity.
The higher the ratio, the more a company relies on debt to finance operations. That tells investors different things about a company’s health, as some companies rely more on debt when they make more extensive investments. Investors may actually prefer a higher debt-to-equity ratio when the company is using leverage to grow its assets.
Still, a lower ratio indicates more cash flow for a company. More conservative investors might seek that out instead, especially if the company pays dividends. Investors of either persuasion use the debt-to-equity ratio to compare potential investments over a specified period of time.
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Debt-to-equity ratio example
Michael is an investor trying to decide what companies he wants to invest in. He looks at the balance sheets of Fuchsia Bovine and Orange Aurochs, two soft drink makers. Fuchsia has assets of $50,000 and liabilities of $20,000, meaning its total equity is $30,000 and its debt-to-equity ratio is 67%. Orange has assets of $100,000 and liabilities of $20,000, meaning its total equity is $80,000 and its debt-to-equity ratio is 25%. Michael sees that Fuchsia’s ratio is higher because it recently borrowed a lot of money to buy new assets, so he sees more long-term growth there.