Debt-to-equity ratio: What it is, why it matters, and how to calculate it

What is the debt-to-equity ratio?

The debt-to-equity (D/E) ratio is a financial leverage ratio that measures the proportion of a company's financing that comes from debt versus the amount that comes from its owners (shareholders). In simple terms, it shows how many dollars of debt a company has for every dollar of equity ¹. 

A company can fund its assets and operations in two primary ways: by taking on debt from lenders (debt financing) or by using money from its owners and retaining profits (equity financing). The D/E ratio directly compares these two sources of capital to reveal a company's reliance on borrowing. This comparison is vital for understanding the company's risk level, as excessive debt can become a significant burden, especially during economic downturns 1.

Why is the debt-to-equity ratio important?

The D/E ratio is a cornerstone of financial analysis for several key reasons. It provides a multi-faceted view of a company's financial health, impacting different stakeholders in unique ways ¹.

For investors

Investors use the D/E ratio to gauge the risk associated with a potential investment.

For example, imagine an investor sees that your company has a very high D/E ratio. While leverage can amplify returns on equity when the company is performing well, it can also magnify losses and increase the risk of bankruptcy if the company fails to meet its debt obligations. To assess the metric further, the investor then analyses the D/E ratio trend in your company and finds that the ratio has been consistently rising over several quarters, which may signal that your company is taking on unsustainable levels of debt to fuel growth ¹.

As a result, the investor concludes that your company is too risky, as most of your revenues may be used to repay debts, leading to a lower return on investment.

For lenders and creditors

Banks, bondholders, and suppliers look at the D/E ratio to assess a company's creditworthiness.

A lower D/E ratio suggests that a company is less reliant on borrowed funds and has a stronger equity cushion to absorb potential losses. This makes it a safer bet to lend to. Conversely, a high ratio indicates that shareholder equity might not be sufficient to cover all liabilities in a liquidation scenario, making lenders more cautious ¹.

For business management

A company's management team closely monitors the D/E ratio to make strategic decisions about its capital structure. The ratio helps them find the optimal balance between debt and equity financing.

Using debt can be a cost-effective way to fund growth (interest on debt is tax-deductible), but too much debt increases financial risk. The ratio serves as a guide for decisions like taking on new loans, issuing more stock, or retaining earnings to strengthen the balance sheet ⁹.

Understanding the main components of the Debt-to-Equity Ratio

Understanding the D/E ratio is important for the sustainability of your business, so it’s essential to calculate and interpret it correctly. Before doing so, you should first understand the concept of its two core components: Total liabilities and shareholders’ equity. Both figures can be found on a company’s balance sheet²

What are total liabilities?

Total liabilities represent all the money a company owes to outside parties. It's the sum of all its legal financial debts and obligations. These are typically broken down into two categories ^3,4:

1. Current liabilities (Short-term debt)

These are debts due within one year. Examples include ³:

• Accounts Payable: Money owed to suppliers for goods or services purchased on credit.
• Short-Term Loans: Bank loans or lines of credit with a repayment period of less than a year.
• Accrued Expenses: Expenses that have been incurred but not yet paid, like wages or taxes.
• Current Portion of Long-Term Debt: The principal portion of a long-term loan that is due within the next 12 months.

2. Non-current liabilities (Long-term debt)

These are obligations due after more than one year. Examples include ⁴:

• Bonds Payable: Money raised from investors through the issuance of bonds.
• Long-Term Loans: Mortgages or other loans with extended repayment schedules.
• Deferred Tax Liabilities: Taxes that are owed but will not be paid until a future date.
• Pension and Lease Obligations: Long-term commitments to employee pension plans or property leases.

When calculating the D/E ratio, it's crucial to use total liabilities, encompassing both short-term and long-term obligations, to get a complete picture of the company's debt burden ¹.

What is shareholder equity?

Shareholder equity (also known as stockholders' equity or book value) represents the net worth of a company. It's the amount of money that would be left for shareholders if all the company's assets were liquidated and all its debts were paid off.

The total shareholder equity is calculated with the fundamental accounting equation ²:

Shareholder Equity=Total Assets−Total Liabilities

Shareholder equity is the capital invested by the owners, plus any profits the company has generated and retained over time. Its main components are ¹⁰:

• Common Stock & Additional Paid-In Capital: The initial capital invested by shareholders when they purchased shares from the company.
• Preferred Stock: A special class of stock with features of both equity and debt.
• Retained Earnings: The cumulative net income the company has earned throughout its history, minus any dividends paid to shareholders. This represents profits that have been reinvested back into the business.

Equity acts as a financial cushion, and a strong equity base signifies a healthier, more stable company.

Debt-to-equity ratio formula and calculation

The formula for calculating the debt-to-equity ratio is straightforward ¹:

Debt-to-Equity Ratio = Total Liabilities / Shareholder Equity

This calculation provides a direct comparison, showing how many dollars of debt exist for every dollar of equity.

Example of debt-to-equity ratio calculation

Let's illustrate with a simple example. Imagine Company ABC has the following figures on its balance sheet for the year:

• Total Assets: HK$5,000,000
• Total Liabilities: HK$2,000,000
• Shareholder Equity: HK$3,000,000

Using the formula:

D/E Ratio =  HK$2,000,000 / HK$3,000,000 = 0.67

This result means that Company ABC has HK$0.67 of debt for every HK$1.00 of equity. This is generally considered a healthy, conservative level of leverage.

How to interpret the debt-to-equity ratio

Interpreting the D/E ratio requires context. A "good" or "bad" ratio is not a universal number; it depends heavily on the industry, the company's stage of development, and its specific business model ¹¹.

A high D/E ratio (e.g., above 2.0)

This indicates that a company relies heavily on debt financing. It's considered highly leveraged. While this can amplify profits (a concept known as financial leverage), it also significantly increases risk. A highly leveraged company must generate sufficient cash flow to cover its principal and interest payments. If its earnings falter, it could face financial distress or even bankruptcy ¹.

A low D/E ratio (e.g., below 1.0)

This suggests a company has a conservative approach and relies more on equity financing. This is generally lower risk and indicates greater financial stability. However, a very low ratio might also imply that the company isn't taking advantage of the potential growth opportunities that debt financing can provide ¹.

A negative D/E ratio

This occurs when a company's shareholder equity is negative, meaning its total liabilities exceed its total assets. This is a major red flag for investors and lenders, as it suggests the company is on the brink of insolvency ¹⁰.

The importance of industry benchmarks:

When calculating the D/E ratio, you can’t judge the result solely by how high or low it is. You also need to compare it with your industry benchmark to gain a clearer understanding of what the ratio means¹¹.

• Capital-intensive industries, such as manufacturing, utilities, and telecommunications, require large investments in machinery and infrastructure. These assets are often financed with long-term debt, leading to naturally higher D/E ratios. Therefore, a D/E of 2.0 might be normal for these types of companies.
• Technology or service-based industries typically have fewer physical assets and may not need as much debt. Their D/E ratios are often much lower, sometimes close to zero. A D/E of 2.0 in this sector would be a serious cause for concern.

When to use the debt-to-equity ratio?

The D/E ratio is a versatile tool used in various financial scenarios ¹:

• Fundamental analysis for investing: Investors use the D/E ratio to compare companies within the same sector. A company with a significantly higher D/E ratio than its competitors may be a riskier investment. It's also useful to track the ratio's trend over time; a steadily increasing ratio can be a warning sign.
• Credit and loan applications: When a business applies for a loan, the lender will perform a thorough debt ratio analysis. The D/E ratio is a key part of this assessment, helping the bank determine the company's ability to take on and service new debt obligations.
• Internal strategic planning: For a company's management, the D/E ratio is a key performance indicator for managing its capital structure. It helps answer strategic questions: "Should we fund our next project with a loan or by issuing new shares?" or "Are our debt levels becoming too risky?"

Debt-to-equity ratio vs. Other ratios

While the D/E ratio is powerful, it shouldn't be used in isolation. A complete balance sheet analysis involves looking at several metrics. Here’s how the D/E ratio compares to other important financial ratios.

Debt-to-equity ratio vs. Cash ratio

• Focus: The D/E ratio measures long-term solvency and leverage. The Cash Ratio ((Cash+Cash Equivalents)/Current Liabilities) measures a company's ability to pay off its short-term debts using only its most liquid assets (cash).
• Key differences: D/E asks, "How is the company's asset base funded?" The Cash Ratio asks, "Can the company pay its immediate bills right now without selling anything?" Each ratio provides different perspectives: long-term structural risk versus immediate liquidity ⁶.

Debt-to-equity ratio vs. Quick ratio

• Focus: The D/E ratio focuses on the overall capital structure. The Quick Ratio, or Acid-Test Ratio, ((Current Assets−Inventory)/Current Liabilities), measures short-term liquidity more broadly than the cash ratio.
• Key differences: The Quick Ratio assesses a company's ability to meet its short-term obligations without relying on the sale of inventory, which may not be easily convertible to cash. While D/E looks at overall leverage, the quick ratio provides a more realistic picture of a company's operational liquidity ⁵.

Debt-to-equity ratio vs. Gearing ratio

• Focus: The terms "gearing ratio" and "debt-to-equity ratio" are often used interchangeably, as both measure a company's financial leverage.
• Key differences: While D/E almost always uses Total Liabilities / Shareholder Equity, "gearing" can sometimes refer to slightly different formulas. For example, some analysts calculate it using only interest-bearing debt in the numerator. Another common variation is the debt-to-capital ratio ((Debt)/(Debt+Equity)). The core purpose is the same—to understand leverage—but it's important to know which specific formula is being used ^7,8.

Tips for improving the debt-to-equity ratio

If a company's D/E ratio is too high, there are several strategic actions it can take to lower it and improve its financial stability:

• Pay down existing debt: The most direct method is to use profits or excess cash to repay outstanding loans and bonds. Prioritising high-interest debt can also improve profitability and cash flow, making future debt management easier.
• Increase equity: A company can bolster its equity base in two main ways:
  
  • Issue more stock: By selling new shares to investors, a company raises cash that increases its shareholder equity, thereby lowering the D/E ratio. The trade-off is potential dilution of ownership for existing shareholders.
  • Boost retained earnings: This is achieved by increasing profitability and retaining a larger portion of net income instead of paying it out as dividends. Stronger operational performance that leads to higher profits naturally strengthens the equity position over time.
• Improve cash flow management: Efficiently managing cash flow ensures that the company can meet its interest-bearing debt obligations without having to take on more debt. This provides the financial stability needed to systematically reduce leverage.

Streamline your cash flow management with Aspire

Improving your company's debt-to-equity ratio starts with having a strong grasp of your finances. The ability to pay down debt and increase retained earnings is directly tied to effective cash flow management.

However, in our experience, small and new businesses often struggle with managing cash flow. For example, they may be unable to track and monitor expenses in real time, which can lead to overspending. They may also find it difficult to chase unpaid receivables, which harms revenue collection. Many of these challenges stem from manual processes, which are not only time-consuming but also prone to human error.

This is where Aspire’s Business Account can help. It streamlines manual processes and gives you full visibility over your finances, enabling you to prepare more accurate, tax-ready financial reports.

With Aspire, you can:

• Get a complete view of your cash inflows and outflows in real time, including the status of accounts payable, receivable, and recurring payments. This makes it easier to forecast future cash movements.
• Get paid faster with integrated invoicing and payment solutions, boosting your incoming cash flow.
• Gain real-time visibility into business expenses, ensuring they stay aligned with your budget.
• Save up to 50% of the time spent on manual accounting tasks with smart automation.
• Eliminate manual data entry with real-time syncing to Xero and QuickBooks.

With Aspire, you’ll spend less time on administrative work and more time growing your business.