Debt to equity ratio: What is it & why use it?

Definition

The debt-to-equity ratio is a financial metric used to assess the proportion of a company’s debt relative to its equity.

What is a debt-to-equity ratio?

This ratio provides insights into how a company is financed, indicating the extent to which it relies on borrowed funds versus funds invested by its owners (shareholders).

To calculate the debt-to-equity ratio, you divide the company’s total debt by its total equity. The formula is as follows:

Debt-to-equity ratio = total debt / total equity

“Total debt” includes both short-term and long-term liabilities, such as loans, bonds, and other forms of debt the company owes. “Total equity” represents the ownership stake of shareholders in the company, which includes common stock, retained earnings, and additional paid-in capital.

The resulting ratio is typically expressed as a number or a percentage. A low debt-to-equity ratio indicates that the company relies more on equity financing, which can be considered less risky because it involves a lower level of debt obligations. On the other hand, a high debt-to-equity ratio suggests that the company has a significant amount of debt relative to its equity, which could indicate a higher financial risk since a larger portion of its operations depends on borrowed funds.

The interpretation of the debt-to-equity ratio depends on the industry and the company’s specific circumstances. Different industries might have varying norms for acceptable levels of debt, and companies with stable cash flows might be more capable of managing higher debt levels than those with volatile cash flows. It’s important to analyse this ratio in the context of other financial metrics and industry benchmarks to get a comprehensive view of a company’s financial health and risk profile.

Example of debt-to-equity ratio

Let’s consider an example for a fictional company, XYZ Corp.:

Total Debt:

XYZ Corp. has long-term debt (e.g., bonds and loans) amounting to ₦800,000.
Short-term debt (e.g., short-term loans) totals ₦50,000.

$Total debt = ₦800,000 + ₦50,000 = ₦850,000$

Shareholders’ equity:

XYZ Corp.’s shareholders’ equity is ₦1,200,000.

Now, using the formula for the debt-to-equity ratio:

$Debt-to-equity ratio = ₦850,000 / ₦1,200,000$ $0.7083$

In this example, XYZ Corp. has a debt-to-equity ratio of approximately 70.83%. This means that for every dollar of shareholders’ equity, the company has ₦0.7083 in debt.