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WIKI ANALYSIS| This article is part of WikiProject Definitions. Consider editing to improve it. View articles referencing this definition. |
The debt to equity ratio is a measure of the company's total long-term debt divided by shareholder's equity
The debt to equity ratio gives the proportion of a company (or person's) assets that are financed by debt versus equity. It is a common measure of the long-term viability of a company's business and, along with current ratio, a measure of its liquidity, or its ability to cover its expenses. As a result, debt to equity calculations often only include long-term debt rather than a company's total liabilities.
A high debt to equity ratio implies that the company has been aggressively financing its activities through debt and therefore must pay interest on this financing. If the company's assets generate a greater return than the interest payments, then the company can generate greater earnings than it would without the debt. If not, however, and the company's debt outweighs the return from its assets, then the debt cost may outweigh the return on assets. Over the long-term, this would lead to bankruptcy. Investors should take this into consideration when investing in a company with a high debt to equity ratio, especially in times of rising interest rates.
Debt to equity ratios vary across industries. Capital intensive industries such as airplane manufacturers tend to have higher debt to equity ratios -- typically greater than 2. Less capital intensive industries, such as a software company, can have lower debt to equity ratios of under .5.
Examples
- To start, Widgets Inc. has long term debt of $1 million and shareholder's equity of $1 million for a debt to equity ratio of 1, which is fairly standard in the widget industry.
- To increase production, Widgets Inc. enters into a loan of $2 million in order to finance a new widget manufacturing facility, which increases its debt to equity ratio to 3 (=[$1 million previous debt + $2 million in new debt]/[$1 million in equity]) . The company pays 5% interest on the loan while its new facilities generate a 7% return. In this case, a higher debt to equity ratio allows the company to increase earnings beyond what would have been possible otherwise. The high debt to equity ratio is worthwhile for the company.
- One year later, however, interest rates on the loan rise to 9%. Now, the company is paying more for its debt than the 7% it is generating out of its new facilities. The company's high debt to equity ratio and increasing debt payments now put the company at risk of going bankrupt.
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