Debt Equity Ratio
Financial Statement Analysis and the Debt Equity Ratio
| The debt equity ratio is the most widely used financial ratio to measure debt levels. |
The debt equity ratio compares total debt to equity. To calculate the debt to equity ratio, divide the total debt by owners equity:
Debt Equity Ratio
| Debt/Owners Equity |
The debt equity ratio indicates how much of the company is financed by debt. A high debt to equity ratio indicates that a company is carrying a high level of 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.
| Company | Debt Equity Ratio |
| S&P 500 | 1.06 |
| Software Industry | .27 |
| Microsoft | .2 |
| Specialty Retail, Other | .5 |
| Sunglasses Hut Int. (Luxottica Group) | .78 |
| Sunny Sunglasses Shop | .39 |
Both MSN and Yahoo Finance only use Long-Term Debt to compute the Debt to Equity Ratio.
As with any financial ratio, owners and investors compare the debt equity ratio to the industry average and the competition.
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.
Using the Debt Equity Ratio and Leverage Ratio
| Loan agreements, notes, and bonds may have debt equity ratios that the company must comply with in order to prevent the loan from going into default. Pressure to comply with debt equity ratios in loan agreements, notes, or bonds to prevent defaults sometimes leads accountants to creatively hide debt.
Enron |
, for example, created entire companies to hide debt levels. More commonly, companies hide debt in various accounts on the balance sheet so that the debt to equity ratio will not pick it up. Financial statement analysis should include measuring the debt to equity ratio with the Additionally, when examining both the debt to equity ratio and the leverage ratio, financial statement analysis includes interest coverage to determine whether or not a company can safely pay additional debt interest.
Sunny Sunglasses Shop’s debt equity ratio is well below industry averages and its main competitor, Sunglasses Hut Int. This means that assets are primarily financed by equity and not debt.
Debt to equity ratios greater than one indicate assets are primarily financed through debt. Consequently, these companies may become more susceptible to higher debt payments and changing economic conditions as a result of carrying higher debt levels.
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