The ratio of debt to equity (or Debt-to-Equity) is a ratio that measures the share of the debts of the company on its equity. It is very useful used in fundamental analysis .
The companies have both equity (money contributed by shareholders) and with money borrowed (liabilities that must be repaid) for operating cycle. Given the different costs of both resources, companies have to find an optimal ratio between both sources of financing.
Through the debt to equity ratio, the company can quickly know what its equity structure is and if it is assumable and efficient. Therefore, the debt-to-equity ratio tells us how much it represents everything the company has borrowed (and involves an interest burden) in relation to everything that the shareholders have put out of pocket.
Calculation of the debt to equity ratio
The debt to equity ratio has a fairly simple calculation. Its calculation formula is as follows:
Example of calculating the debt to equity ratio
Let us suppose that the company Exentis Corp presents the following balance sheet.
Applied the formula, we would have the following ratio on own resources.
Net financial debt is in the denominator. In the case of this example, it would be the long-term liability (debt to / p with credit institutions) and the short-term liability with cost (ac / p debt with credit institutions). The denominator includes the net worth, that is, the company’s own resources.
Interpretation of the debt to equity ratio
Although the calculation is simple when interpreting it, you have to know how it was calculated. This is because depending on the analyst or the data provider, it can sometimes be calculated in different ways. In general, net financial debt is considered to be long-term debt ( non-current liabilities ) and interest-bearing short-term debt (short-term liabilities with cost). These are the debts that generate an interest payment and therefore represent a cost for the company.
As always when interpreting the ratios, the company and the sector must be taken into account. A ratio above 2 could be alarming due to the high degree of leverage. A ratio of 1 would tell us that the company combines equally debts and other people’s resources. And a ratio below 0.4 is considered as the company has a very conservative management and does not want to take risks with the debt.