This ratio is calculated by dividing long-term debt by total shareholders’ equity. This figure is not provided for financial companies.
Benefit
The debt/equity ratio shows the mix between long-term debt and shareholders’ equity—the two main sources of long-term financing for companies. The higher the ratio, the more heavily a company relies on debt for capital.
Origin
The company’s long-term debt is found under the liabilities area of the company’s balance sheet. Total shareholder’s equity is found under the total shareholder’s equity section of the balance sheet.
For the Pros
Typically the higher the debt/equity ratio, the more volatile a company’s earnings will be. That’s because the higher debt is, the higher interest expenses are, and a fixed cost like interest can cause wide swings in earnings. But different companies can support different debt/equity levels. Companies operating in steady businesses like electric utilities or food producers can afford to carry a high debt/equity ratio. More cyclical companies, though, court trouble by carrying a lot of debt. Also worrisome is a company whose debt/equity ratio has risen over time; it could be a sign the company is having to turn to creditors to raise cash.