1. Debt Ratios: Introduction
  2. Debt Ratios: Overview Of Debt
  3. Debt Ratios: The Debt Ratio
  4. Debt Ratios: Debt-Equity Ratio
  5. Debt Ratios: Capitalization Ratio
  6. Debt Ratios: Interest Coverage Ratio
  7. Debt Ratios: Cash Flow To Debt Ratio

The debt-equity ratio is another leverage ratio that compares a company's total liabilities to its total shareholders' equity. This is a measurement of the percentage of the company’s balance sheet that is financed by suppliers, lenders, creditors and obligors versus what the shareholders have committed. 
 
The debt to equity ratio provides another vantage point on a company's leverage position, in that it compares total liabilities to shareholders' equity as opposed to total assets in the debt ratio. Similar to the debt ratio, a lower percentage means that a company is using less leverage and has a stronger equity position. 
 
The ratio is calculated by dividing the company’s total liabilities by its shareholder’s equity.
 
 
Like the debt ratio, this ratio is not a pure measurement of a company's debt because it includes operational liabilities as part of total liabilities.
 
Additionally, what constitutes a “good” or “bad” result will vary by industry. For example, an industry such as telecommunications and other types of utilities require substantial up-front and frequent ongoing capital investment.
 
These expenditures are often financed by borrowing so, all else being equal, their debt-equity ratio would be on the high side.
 
Utilities generally have a high level of debt because they can. Most electric utilities are virtual monopolies and have little or no competition. Unless the population in their service area were to rapidly decline, they can assume pretty stable revenues and cash flows, so they know with a high level of certainty how much they will have to service their debt on an ongoing basis.
 
The banking industry is another area with typically high levels of debt to equity. They use borrowed money to make loans at higher rates of interest than they are paying for the funds they borrow. This is one of the ways they make a profit.
 
The real use of debt-equity is in comparing the ratio for firms in the same industry. If a firm’s debt-equity ratio varies significantly from its competitors or the averages for its industry, this should raise a red flag. Companies with a ratio that is too high can be at risk for financial problems or even a default if they can’t meet their debt obligations.
 
On the other hand, companies employing too little leverage may be earning less than their competitors as a result.

 

 


Debt Ratios: Capitalization Ratio
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