The debt/equity ratio (or debt to equity ratio) is the total amount of debt divided by the amount of shareholder's equity. It is a measure of leverage and how much of the company's capital structure is due to debt.
There are two sources of funds for companies to use to pay for their operations and to grow. These are equity (primarily retained earnings and money raised from selling shares of the company) and debt (borrowings from banks or from other investors through things like bonds).
Debt, or "leverage," is not necessarily a bad thing. It is a cheaper form of financing than equity. (Investors generally require a higher level of return than the interest charged on debt.) Thus, it can let companies do things at a lower cost than would otherwise be possible. Because of this, using debt increases the return to shareholders.
However, as was amply demonstrated in the fall of 2008, too much leverage can lead to company meltdown as they discover they cannot pay their obligations.
The debt/equity ratio (or D/E ratio) is a measurement of this leverage. It shows how much of the company's capital structure is from debt. A ratio of 1.0 means that half the structure is from debt, half is from equity. Depending on the industry the company operates in, different levels are considered optimal, so be sure to calculate this ratio for other companies in the same industry to see if yours is in line or not.
In adding up the debt, the investor should, of course, include both the long-term and short term debt found on the balance sheet. But there are several other items that should, ideally, be included. These are often found off the balance sheet, down in the footnotes, and include:
- Lease obligations
- Notes payable
- Capital leases
There are a couple of wrinkles to this ratio, as well (of course). For instance, share buybacks, where the repurchased shares are put on the balance sheet and subtracted from the equity balance. This has the effect of lowering the equity level, which raises the D/E ratio. If the company had borrowed to do that repurchase and had not yet repaid that debt, then the ratio is even higher. Of course, conservative investors could recognize that and then use those numbers as they are, to set the hurdle higher.