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.

  1. If a company has a high debt to capital ratio, what else should I look at before ...

    Learn about some of the financial leverage and profitability ratios that investors can analyze to supplement examining the ... Read Answer >>
  2. 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 >>
  3. What are financial risk ratios and how are they used to measure risk?

    Explore some of the primary financial risk ratios that investors and analysts commonly use to evaluate a company's overall ... Read Answer >>
  4. Why do shareholders need financial statements?

    Discover the importance of a company's financial statements for stock shareholders in evaluating their equity investment ... Read Answer >>
  5. How does a company choose between debt and equity in its capital structure?

    Learn about the benefits and drawbacks of debt and equity financing. Find out how to compare capital structures using cost ... Read Answer >>
  6. What is the difference between cost of debt capital and cost of equity?

    Learn about how the costs of debt and equity capital differ and how to calculate each using interest and tax rates and stock ... Read Answer >>
Related Articles
  1. Investing

    Debt Ratios

    Learn about the debt ratio, debt-equity ratio, capitalization ratio, interest coverage ratio and the cash flow to debt ratio.
  2. Investing

    Target Corp: WACC Analysis (TGT)

    Learn about the importance of capital structure when making investment decisions, and how Target's capital structure compares against the rest of the industry.
  3. Investing

    Why do Debt to Equity Ratios Vary From Industry to Industry?

    Obtain a better understanding of the debt/equity ratio, and learn why this fundamental financial metric varies significantly between industries.
  4. 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 ...
  5. Investing

    Equity Multiplier

    The equity multiplier is a straightforward ratio used to measure a company’s financial leverage. The ratio is calculated by dividing total assets by total equity.
  6. Investing

    Key Financial Ratios to Analyze Tech Companies

    Understand the technology industry and the companies that operate in it. Learn about the key financial ratios used to analyze tech companies.
  7. 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 ...
  1. Capitalization Ratios

    Capitalization ratios are indicators that measure the proportion ...
  2. Leverage Ratio

    A leverage ratio is any one of several financial measurements ...
  3. Debt Ratio

    The debt ratio is a financial ratio that measures the extent ...
  4. Capital Structure

    Capital structure is how a firm funds its operations and growth, ...
  5. Long-Term Debt To Total Assets Ratio

    The long-term debt to total assets ratio is a measurement representing ...
  6. Debt Service

    Debt service is the cash that is required for a particular time ...
Trading Center