Debt / Capital Ratio

economic-dictionary

The debt-to-equity ratio (Debt / Equity) is a solvency ratio that measures the ratio of total debt to capital employed by the company. In English it is known as debt to capital.

To finance their activity, companies use their own or third-party resources. Depending on the costs of each one, companies have to find the optimal capital structure to finance their activity.

Therefore, the debt-to-equity ratio allows us to know the proportion of debt that a company uses to finance its activity in relation to the total capital employed.

Interpretation of the debt to equity ratio and its utility

The debt-to-equity ratio is very useful to understand the capital structure of companies. It is commonly used in fundamental analysis, as it allows the capital structure and solvency to be compared between comparable companies.

It must be taken into account that there may be 2 companies with the same level of debt in absolute terms, but that nevertheless this level affects them very differently. In other words, a company may have a very high payment capacity and, on the contrary, another company could be in serious trouble to service that level of debt on the total capital.

Given that companies have to pay a cost for their debt, we can easily deduce that the higher this ratio is for a company, the greater the risk involved in investing in it.

Cost of debt

Example of calculating the debt-to-equity ratio

The debt-to-equity ratio has a simple calculation. For this, the following formula is used:

The numerator includes the total debt of the company and the denominator includes all the capital employed. That is, both debt and equity. Depending on the analyst or data provider, total debt can be defined in different ways. Generally, total debt is understood as long-term debt plus short-term cost debt, that is, short-term debt that bears interest.

Let's imagine that company A has a total debt of € 500,000 and that the sum of its debt plus its own resources is € 1,000,000. Company B has a total debt of € 500,000 and the sum of its debt and its own resources is € 800,000.

Debt to equity ratio A: 500,000 / 1,000,000 = 0.5
Debt to company capital ratio B: 500,000 / 800,000 = 0.625

In the example we can see that although the 2 companies have the same level of debt, company B is using a higher proportion of debt to finance its activity. Therefore, company B would be more leveraged than company A and would present a riskier investment a priori.

Solvency ratios

There is another similar solvency ratio, which is the Debt / Equity Ratio, which divides debt directly over equity. So in this case the ratio may be greater than one, if the debt is greater than the equity.

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