A:

When analyzing the financial health and growth potential of a company, business owners and investors look to financial ratios that indicate how a company is funded and how effectively those dollars are being used. In ratio analysis, the debt to equity ratio is widely considered the best reflection of a company's capital structure.

As the name implies, the debt to equity ratio compares a company's total liabilities to its total equity financing. A high debt to equity ratio indicates that a business receives a much greater proportion of its capital funding from lenders rather than shareholders. However, a large amount of debt is generally considered a sign of risky business practices; payments on that debt are required by law regardless of business revenues. A company with a high debt to equity ratio that experiences a financial downturn must continue to make payments on its debts even if the business fails to generate enough revenue to cover them; this can quickly lead to loan default and bankruptcy. Generally, a lower debt to equity ratio is preferred by both investors and lenders.

On the other hand, debt financing allows a company to leverage existing capital to fund expansion at an accelerated rate. A debt to equity ratio of 0 (indicating no debt financing) is a sign that the company is potentially missing out on important opportunities to grow the business. A growing business means increased profits for both owners and shareholders, so a company that ignores debt financing entirely may be doing a disservice to its investors. The debt to equity ratio offers concrete information about the balance of a company's capital funding and the relative risk of its business model.

The optimal balance of debt and equity varies from business to business and industry to industry, so the debt to equity ratio is best used as a comparative metric between companies in the same sector. To ensure a comprehensive financial analysis, the individual business's operational model, profitability metrics and historical performance must all be considered when looking at the debt to equity ratio.

RELATED FAQS
  1. What is considered a good net debt-to-equity ratio?

    Learn about the maximum acceptable debt to equity ratio, what it means about a company's capital structure and why the optimal ... Read Answer >>
  2. Why would a company use a form of long-term debt to capitalize operations versus ...

    Learn about the different consequences of using long-term debt versus equity to raise capital for business activity, and ... Read Answer >>
  3. How does a company's capitalization structure affect its profitability?

    Learn about capitalization structure and how the combination of debt and equity a company uses to fund operations can affect ... Read Answer >>
  4. Is debt a relatively cheaper form of finance than equity?

    When financing a company, the cost of obtaining capital comes through debt or equity. Find out which method generally provides ... Read Answer >>
  5. What is the formula for calculating the current ratio?

    Find out what makes up the current ratio, how to calculate it, and what the result can tell you about a potential investment. Read Answer >>
  6. How do you calculate the ratio between debt and equity in the cost of capital

    Discover how to calculate the ratio between debt and equity when making cost of capital estimations using the weighted average ... Read Answer >>
Related Articles
  1. Investing

    Understanding Leverage Ratios

    Large amounts of debt can cause businesses to become less competitive and, in some cases, lead to default. To lower their risk, investors use a variety of leverage ratios - including the debt, ...
  2. Investing

    4 Leverage Ratios Used In Evaluating Energy Firms

    These four leverage ratios can help investors evaluate how energy manage their debt.
  3. Investing

    Debt Reckoning

    Learn about debt ratios and how to use them to assess a company's financial health. You could save a lot of money!
  4. Financial Advisor

    The Debt To Equity Ratio

    The debt to equity ratio identifies companies that are highly leveraged and therefore a higher risk for investors. Find out how this ratio is calculated and how you can use it to evaluate a stock.
  5. Investing

    Analyzing AT&T's Debt Ratios in 2016 (T)

    Learn about AT&T Inc. and its key debt ratios, such as the debt-to-equity ratio, interest coverage ratio and cash flow-to-debt ratio.
  6. Investing

    Analyzing Wal-Mart's Debt Ratios in 2016 (WMT)

    Analyze Wal-Mart's debt-to-equity ratio, interest coverage ratio and cash flow-to-debt ratio to evaluate the company's financial health and debt management.
  7. Investing

    Ratio Analysis

    Ratio analysis is the use of quantitative analysis of financial information in a company’s financial statements. The analysis is done by comparing line items in a company’s financial ...
  8. Investing

    Sysco and Other Big Movers In Services

    The market has been slipping so far today. The Nasdaq has fallen 0.3%; the S&P 500 has fallen 0.4%; and the Dow has declined 0.5%. The Services sector (IYC) is currently lagging behind the overall ...
  9. Investing

    Lowe's Stock: Capital Structure Analysis (LOW)

    Examine Lowe's Companies' equity capitalization, debt capitalization and enterprise value to analyze trends in the retailer's capital structure.
RELATED TERMS
  1. Capitalization Ratios

    Capitalization ratios are indicators that measure the proportion ...
  2. Funded Debt

    A funded debt is a company's debt that will mature in more than ...
  3. Long-Term Debt to Capitalization Ratio

    The long-term debt to capitalization ratio, calculated by dividing ...
  4. Debt Financing

    Debt financing occurs when a firm raises money for working capital ...
  5. Ratio Analysis

    A ratio analysis is a quantitative analysis of information contained ...
  6. Optimal Capital Structure

    An optimal capital structure is the mix of debt, preferred stock and common ...
Trading Center