Ratio analysis converts information from traditional financial statements to detailed statistical figures. Stakeholders often use ratios to determine whether a company is operating better in current periods as opposed to earlier accounting periods. Measuring total liabilities to equity determines a company’s use of financial leverage. Accountants refer to this process as the debt to equity ratio.
The debt to equity ratio divides a company’s total liabilities by shareholder’s equity. Total liabilities represent all monies owed to businesses outside of a company. In other terms, liabilities are claims against a company’s assets. Shareholder’s equity is the money investors place into a company in order to generate a financial return from dividends or stock price increase.
A company has $115,000 in total liabilities and $325,000 in shareholder’s equity. The company’s debt to equity ratio is .35 based on these numbers. High figures indicate a company uses aggressive debt financing to grow the company’s operations. A single standard for good or bad debt to equity ratios does not exist. The purpose of the ratio is to compare debt use in one company against the industry standard.
A low debt to equity ratio does not indicate a company is operating efficiently. This ratio fails to consider the loan terms for long-term debt included in the company’s total liabilities. For example, a $25,000 loan included in the example above may have an 18 percent interest rate and $5,000 balloon payment required in two years. These loan features can be quite restrictive on a company’s cash, which this ratio does not consider.
Capital-intensive industries often have higher debt to equity ratios than other industries. This is normal because companies with high capital requirements generally need money to conduct operations or engage in research and development activities. The automotive and pharmaceutical industries are common examples of capital-intensive industries. Ratio results for these industries can be well over 1.0 on a frequent basis.
- "Intermediate Accounting"; David Spiceland, et al.; 2007