The debt-to-equity (D/E) ratio is an important leverage metric in corporate finance. It is a measure of the degree to which a company is financing its operations through debt versus wholly owned funds. More specifically, it reflects the ability of shareholder equity to cover all outstanding debts in the event of a business downturn.
Defining the Debt-to-Equity Ratio
The D/E ratio is calculated by dividing total debt by the total shareholder equity. Though it is a simple calculation, this ratio carries a lot of weight. While the optimal ratio varies from industry to industry, companies with very high D/E ratios are often considered to be a greater risk by investors and lending institutions. A greater degree to which operations are funded by borrowed money means a greater risk of bankruptcy if business declines. Minimum payments on loans and other debts must still be met even if, due to economic downturn or simple market competition, a business does not turn enough profit to meet its obligations. For a highly leveraged company, a particularly bad quarter could end in disaster.
However, it's not as simple as saying a high D/E ratio is a sign of poor business practices. In fact, a certain amount of debt can actually be the catalyst that allows a company to expand operations and generate additional income for both the business and its shareholders. Some industries, such as the auto and construction industries, typically have higher ratios than others because getting started and maintaining inventory are capital-intensive. Companies with intangible products, such as online services, may have lower standard D/E ratios. Therefore, it's important to consider a company's historical ratio, as well as the D/E ratios of similar companies in the same industry, when evaluating financial health. (For related reading, see "What Is the Best Measure of a Company's Financial Health?")
Calculating the Debt-to-Equity Ratio in Excel
Business owners use a variety of software to track D/E ratios and other financial metrics. Microsoft Excel provides a number of templates, such as the debt ratio worksheet, that perform these types of calculations. However, even the amateur trader may want to calculate a company's D/E ratio when evaluating a potential investment opportunity, and it can be calculated without the aid of templates.
To calculate this ratio in Excel, locate the total debt and total shareholder equity on the company's balance sheet. Input both figures into two adjacent cells, say B2 and B3. In cell B4, input the formula "=B2/B3" to render the D/E ratio.
A Brief Example of the Debt-to-Equity Ratio
The owner of a bookshop wants to expand his or her business and is looking to leverage existing capital by taking on an additional loan. Because the book sales industry is beset by new digital media, a business with a large amount of debt would be considered a risky prospect by creditors. However, upon reviewing the company's finances, the loan officer determines the company has debt totaling $60,000 and shareholder equity totaling $100,000. With a D/E ratio of 0.6, the business should be able to take on some additional outside funding without being too highly leveraged.
(For related reading, see "Why Do Debt to Equity Ratios Vary from Industry to Industry?")