Debt-to-equity ratio

Every company pays for its assets in two ways: with money it borrows and with money that belongs to its shareholders. Shareholders' equity is the second part: what owners invested plus the profits kept in the business over the years, minus what was paid back to them.

A D/E of 0.5 means the company owes 50 cents to lenders for every dollar of equity. A D/E of 2 means it owes two dollars. Lenders are paid interest whatever happens, so the more a company borrows, the less room it has when profits fall.

Both numbers come from the balance sheet. Total debt is short-term and long-term borrowings: bonds, bank loans and, in most definitions, finance leases. Shareholders' equity is the last section of the balance sheet.

Some sources divide total liabilities by equity instead. That version also counts suppliers' bills, deferred revenue and pension obligations, so it gives a higher number for the same company. Check which version a figure uses before comparing it with another.

A company has $300 million of debt and $600 million of equity. Its D/E is 300 ÷ 600 = 0.5.

It then borrows another $300 million and spends it repurchasing its own shares. Debt grows to $600 million, and equity shrinks to $300 million, because the money left the company. D/E jumps to 600 ÷ 300 = 2, although the business itself has not changed.

Equity can fall below zero. Years of buybacks and dividends larger than profits, or losses piled up over many years, can push it there. The ratio then turns negative or becomes extremely large, and it stops saying anything useful.

Negative equity does not by itself mean a company is in trouble. A business with steady cash flows can pay out more than it keeps for many years. It does mean that D/E cannot be used to judge its debt, and a measure based on earnings or cash flow is needed instead.

The same measure, worked out from the annual reports of eight large companies, next to debt to EBITDA: debt compared with a year of operating profit before depreciation and amortisation.

The two ratios do not always agree. A company that has returned a lot of money to shareholders can show a high or meaningless D/E while its debt is a modest multiple of what it earns in a year. A company with little debt and large cash balances shows low numbers on both.

• There is no single good number. Utilities, telecoms and real estate companies have steady income and large physical assets, so they usually carry more debt than software or chip companies.
• Compare a company with others in its own industry and with its own history. A D/E that keeps rising year after year deserves a closer look at why the company borrows.
• Look at what the debt costs and when it is due. Debt at a fixed low rate due in ten years weighs less than debt that must be refinanced next year.
• Check the debt against earnings and cash, not only against equity. Debt to EBITDA and interest coverage show whether the company can actually carry it.

• Equity is a book value. Buybacks, write-downs and old accounting choices change it without changing the business, which moves D/E as well.
• Definitions differ: total debt or total liabilities, with or without leases, gross or net of cash. Two websites can show different D/E for the same company and both be right by their own definition.
• Cash is ignored. A company with as much cash as debt and one with no cash can show the same D/E.
• For banks and insurers borrowing is the raw material of the business, so their D/E is very high by nature and is not comparable with other companies.

• PlainTicker does not rank companies by D/E. Each company page shows net debt: all borrowings, including finance leases when the company reports them together, minus cash. Operating leases are left out. When complete debt or cash is unknown, the value is shown as unavailable rather than estimated.
• Next to it, debt to EBITDA is compared with the company's sector, and its trend is shown over the years.
• The Piotroski F-Score checks debt too: one of its nine checks asks whether long-term debt fell as a share of total assets from the previous year.
• Debt measures are not used for banks and brokers, whose borrowing is their operating funding.