The debt to equity ratio formula compares a company’s total debt to total equity. In other words, it shows a relation between a percentage of company’s assets financed by creditors and percentage of assets financed by investors.

This ratio informs about the level of indebtedness of the company’s equity and about the relation of external capitals to equity as sources of company financing. A higher ratio means that a company is mostly financed by external sources (loans) and a lower ratio means that a company is mostly financed by internal sources (shareholders’ investments).

### How to calculate debt to equity ratio?

Debt to equity ratio is calculated by dividing total liabilities by total equity. These number can easily be found in the balance sheet.

$$Debt\;to\;Equity = \frac{Total\;Liabilities}{Total\;Equity}$$

The structure of the ratio shows that the higher the value of the ratio, the higher the share of external financing in funding the company’s assets. Having a high level of debt involves the risk of insolvency, i.e. an excessively indebted company, at some point may lose its ability to pay back the borrowed funds.

### Debt to equity ratio explained

In short, the higher the value of the ratio, the higher the company’s debt and, consequently, the greater is the risk associated with this investment.

• Debt to equity ratio > 1.

If the D/E ratio is greater than 1, that means that a company is primarily financed by creditors. For example, debt to equity ratio of 1,5 means that the assets of the company are funded 2-to-1 by creditor to investors, in other words, 2/3 of assets are funded by debt and 1/3 is funded by equity.

• Debt to equity ratio < 1.

If the D/E ratio is less than 1, that means that a company is primarily financed by investors. For example, debt to equity ratio of 0,5 means that the assets of the company are funded 2-to-1 by investors to creditors, in other words, 2/3 of assets are funded by equity and 1/3 is funded by debt.

• Debt to equity ratio = 1.

If the D/E ratio is 1, that means that a half of a company’s assets is funded by creditors and half by investors.

Usually, lower debt to equity ratio is more favorable, because that means that the company is financially stable. Lower D/E ratio demonstrates the company’s financial strength and ability to finance its activities and assets.

Companies with higher debt to equity ratio are considered to be riskier and less stable. Debt financing also involves additional costs, which are usually higher than costs related to shareholders’ capital. However, companies with higher debt to equity level can get additional benefits of using the financial leverage.  Financial leverage allows the company to achieve above-average incomes by partly financing its activities with borrowed capital. For example, a company can purchase an asset or invest in a new project by using borrowed funds, and the rate of return from these investments will be higher than borrowing cost.

Every industry is characterized by a certain specificity of the capital structure. High debt level can be quite natural in some types of business. Therefore, the value of the debt to equity ratio should be compared with the industry average or other competitors, like all financial ratios. It is also important to examine the changes in the value of the ratio over several periods and to try to identify the trends.

### Example of debt to equity calculation

A company reports the following accounts on its balance sheet:

• Liabilities
• Accounts payable $30,000 • Short-term bank loan$30,000
• Long-term debt $60,000 • Stockholder’s equity • Common stock$100,000
• Preferred stock $50,000 $$Debt\;to\;Equity = \frac{\30,000 + \30,000 + \60,000}{\100,000 + \50,000} = 0.8$$ The ratio of 0.8 means that the company is mainly financed by shareholders. It means that this company has$1 of equity for each \$0.8 of debt.