What Is the Debt Equity Ratio?

What Is the Debt Equity Ratio?

By Charles Joseph | Editor, Financial Affairs
Reviewed by Corey Michael | Senior Financial Analyst

The Debt Equity Ratio is a financial ratio that compares a company’s total debt to its total equity. This indicates the proportion of a company’s funding that comes from debt as compared to equity (shareholders’ investments). A high ratio could indicate a business is heavily funded by debt and might be risky to investors, while a low debt-equity ratio may signal that the company is more stable and less risky from an investment perspective. The ideal ratio can vary significantly by industry.

Related Questions

1. How is the Debt Equity Ratio calculated?

Debt Equity Ratio is computed by dividing a company’s total liabilities (debts) by its shareholder equity. These figures can be found in the balance sheet of the company’s financial statements.

2. Why is the Debt Equity Ratio important?

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The ratio offers investors a quick way to measure the level of risk associated with particular companies. Businesses with high debt compared to equity may find it hard to cover their debts if revenues decline, compared to firms with a lower ratio.

3. What is a good Debt Equity Ratio?

Generally, a Debt Equity Ratio of 1.0 (100%) or lower is considered good, and means the company has less debt compared to its equity. But the acceptable ratio varies across industries. For instance, capital-intensive industries like utilities and manufacturing might have higher ratios compared to industries like technology.

4. What are the disadvantages of a high Debt Equity Ratio?

A high ratio indicates greater risk to investors and lenders, if the company’s income falls, it may struggle to meet its debt obligations. Additionally, it could lead to higher interest rates for borrowing due to increased risks perceived by lenders.

5. How to use the Debt Equity Ratio for investment decisions?

Investors use this ratio as one factor in assessing a company’s risk. A higher ratio may signal higher risk, so investors demand higher expected returns as compensation. Conversely, a lower ratio suggests the opposite – lower risk and potentially lower returns.