Description: This ratio is one of the most closely watched by creditors and investors, because it reveals the extent to which company management is willing to fund its operations with debt, rather than equity. For example, a company that wants to increase its return on equity can do so by obtaining debt, which it then uses to buy back stock, thereby shrinking the amount of equity that is used to calculate the return on equity. This strategy works for as long as the after-tax interest cost of the debt does not exceed the benefit of the increased earnings per share resulting from the reduction in shares.
Lenders are particularly concerned about this ratio, since an excessively high ratio of debt to equity will put their loans at risk of not being repaid. Possible requirements by lenders to counteract this problem are the use of restrictive covenants that force excess cash flow into debt repayment, restrictions on alternative uses of cash, and a requirement for investors to put more equity into the company.
Formula: Divide total debt by total equity. For a true picture of the amount of debt that a company has obtained, the debt figure should include all operating and capital lease payments. The formula is as follows:
Debt
Equity
A more restrictive view of the formula is to only include long-tem debt in the numerator, on the assumption that this variation gives a better picture of a company’s long-term debt to equity structure. However, this view excludes situations where short-term debt, such as revolving credit lines, cannot be paid off in the short-term, and must eventually be converted into long-term debt, thereby increasing the amount of long-term debt.
Cautions: One should consider calculating the debt to equity ratio for several years into the future, focusing on the relationship between interest and principal payments (rather than total debt) and equity for each year. The reason for this approach is that a large amount of total debt on the balance sheet may not reveal a true picture of a company’s ability to pay it off if the debt is not due for payment until a required balloon payment at some point well into the future. On the other hand, a much smaller amount of debt on the balance sheet may be completely unsupportable if the bulk of it is due for payment in the near term.