IBD Meet-Up

El Macero, CAApril 25, 2013

Definition of ‘Debt/Equity Ratio’

EQUATION

Debt/Equity Ratio = __TOTAL LIABILITIES___ STOCKHOLDERS’ EQUITY

(Stockholder’s equity = assets – liabilities)

Note: Sometimes only interest-bearing, long-term debt is used instead of total liabilities in the calculation.

Also known as the Personal Debt Equity Ratio, this ratio can be applied to personal financial statements as well as corporate ones.

A measure of a company’s financial leverage calculated by dividing its total liabilities by stockholders’ equity.

It indicates what proportion of equity and debt the company is using to finance its assets.

A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt.

This can result in volatile earnings as a result of the additional interest expense.

The debt/equity ratio also depends on the industry in which the company operates.

For example, capital-intensive industries such as auto manufacturing tend to have a debt/equity ratio above 2, while personal computer companies have a debt/equity of under 0.5.

A company can change its capital structure by issuing debt to buy back outstanding equities or by issuing new stock and using the proceeds to repay debt.

Issuing new debt increases the debt-to-equity ratio; issuing new equity lowers the debt-to-equity ratio.

A good rule of thumb on debt is to be careful about a company whose debt/equity ratio is >20%

My watchlist spreadsheet includes the following:

Finance companies tend to have higher debt/equity ratios due to the nature of their business.