Using the Debt Equity RatioThe Debt Equity Ratio is one of the most widely used Financial Ratios. It divides Total Debt by Owner's Equity.
The ratio indicates how much of the company is financed by debt. The higher the ratio, the higher the debt. Generally, ratios of higher than 1 indicate more risk in financing assets. Some calculations only use long-term interest bearing debt, defined as debt with a maturity date of longer than one year. Analysts may prefer Long-Term Debt/Owner's Equity since income generating assets are generally financed with Long-Term Debt.
As with any Financial Ratio, owners and investors compare the ratio to the industry average and the competition. Microsoft has a ratio of zero because it has no long-term debt. When companies can leverage assets for a profitable return, debt adds value to the company by increasing returns. However, when a company uses too much debt, it becomes vulnerable to rising interest rates, recessions, or economic downturns in cyclical industries. For this reason, when examining both debt to equity ratio and the leverage ratio, owners and investors review the Interest Coverage Ratio to determine whether or a company can safely pay additional interest expenses. Sunny Sunglasses Shop's ratio is well below industry averages and its main competitor. This means that assets are primarily financed by equity and not debt. Ratios of greater than 1 indicate assets are primarily financed through debt. Consequently, the company may become vulnerable to changing economic conditions by carrying high debt levels.
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