Debt-to-equity ratio

The formula

• D/E = D / E

D is the total debt and E the shareholders’ equity. The ratio says how many units of borrowed money stand behind each unit of the owners’ own.

A worked example

Debt of 600,000 and equity of 400,000: D/E = 600,000 / 400,000 = 1.5. The lenders have put in one and a half times what the owners have. Turned round, an owner who wants to keep the ratio at 1.5 with 400,000 of equity can carry 600,000 of debt.

The same fact as the equity ratio

Debt plus equity is the total capital, so D/E and the equity ratio describe one balance sheet from two sides. With D/E = 1.5 the equity is 400,000 of 1,000,000, an equity ratio of 40%; the conversion is equity ratio = 1 / (1 + D/E). Analysts use one or the other by habit.

What borrowing does

Debt costs interest whatever the year brings, and equity costs nothing until there is a profit to share. That makes debt cheap in a good year and dangerous in a bad one: with D/E at 1.5, a loss of 400,000 wipes out the owners while the lenders are still owed in full. The same leverage is what lifts the return on equity above the return on assets.

Common mistakes

• Counting only the interest-bearing debt, or all liabilities, without saying which. Both conventions are in use and they give different ratios.
• Comparing a bank with a manufacturer. A bank’s business is to carry debt; its ratio is on another scale.
• Reading it as a verdict. 1.5 is heavy for one industry and light for another.

Frequently asked questions