In corporate finance, the two primary sources of financial capital for businesses are debt and equity. Debt comes in the form of loans or bond obligations that carry interest, whereas equity grants ownership and voting rights. The relationship between these two sources of funding is known as the interest bearing debt ratio or, more simply, the debt ratio or debt to equity ratio.
The two types of liabilities a company has are long-term debt and short-term debt. Short-term debt consists mostly of accounts payable, such as money owed to a supplier of raw materials. This debt rarely carries interest. The other type of debt is long-term debt, which consists of loans from banks or money owed to purchasers of corporate bonds issued by the company. This debt carries interest rate obligations the company must meet until the principal is paid off.
Equity is the other primary source of financing for companies. Equity funding is raised by selling shares of the company's stock to investors. When an investor purchases a share of stock, he becomes a partial owner of the company, with rights to a share of the company's profits and a right to vote for the company's board of directors.
The interest-bearing debt ratio, or debt to equity ratio, is calculated by dividing the total long-term, interest-bearing debt of the company by the equity value. For example, if a company is financed with $6 million in debt and $4 million in equity, the interest-bearing debt ratio would be $6 million divided by $4 million, which could be expressed variously as 1.5 or 3:2.
The interest-bearing debt ratio is significant because it gives a window into the financial health of a company. Just as with individuals, if a corporation has a substantial amount of debt relative to its equity, it may be at risk of defaulting on those loans and going bankrupt. If a company were to go bankrupt, it is possible that an investor would lose his entire investment in that company.