Debt to Equity Ratio
Shareholders equity = total assets - total liabilities. What's leftover after all liabilities (debt) are paid off is called shareholders equity.
How to use debt to equity ratio
- Lower is better
- below 2 is considered healthy (always use industry average)
- Can be very different between industries
- Can be used to compare companies
Why do investors use the debt to equity ratio in their analysis
It shows how much debt the company used to finance their operations.
Things to be aware of
- Only compare with other companies in the same industry.
- Not all debt is equally risky (for example, short term risk is less risky).
How to calculate debt to equity ratio
Debt to equity ratio = total debt / shareholders equity
Real life example
Debt to equity measures the total debt versus the total shareholders equity. While the total debts to total assets ratio uses total assets, the debt to equity ratio looks at the total equity of shareholders. Where equity of shareholders are:
- Common shares
- Preferred shares
- Retained earnings (net profits after dividend payments)
You can find the shareholders' equity in the balance sheet. A ratio between 0,5 and 1,5 is preferred. If the ratio is above 1.5, that would indicate creditors have significantly more stake (debt) in the company than the shareholders. In other words, the company is using a lot of debt to finance their operations.
Not all debt is equally risky. Meaning you can adjust the ratio by including or excluding certain amounts of debt. Short term debts are less risky because they have to be paid back within one year anyway. It’s much easier to plan one year ahead versus five or ten years.
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