Debt Equity Ratio
Debt equity ratio is calculated by dividing a company’s total liabilities by stockholder’s equity:Debt Equity Ratio = Total Liabilities / Total Equity (Eq. 1)
It gives investors an idea how a company has been aggressively borrowing money to grow its business. High debt equity ratio indicates that the company is aggressively expanding its business by using a large portion of capital that is not its own. If the incremental profit generated by expanding is higher than the cost of interests, the company is generating more profit compared to the scenario had company not borrowed the money. On the other hand, the company could generate larger than expected loss if the result doesn’t go well.
Debt Ratio
Similar to debt equity ratio, debt ratio is calculated by dividing a company’s total liabilities by its total assets, which is a company’s total liabilities plus total stockholder’s equityDebt Ratio = Total Liabilities / Total Assets (Eq. 2)
From Eq. 1 and Eq. 2, we can derive:
Debt Ratio = Debt Equity Ratio / (1+Debt Equity Ratio) (Eq. 3)
Note from Eq. 3 we can see that Debt ratio always greater than or equal to 1 since debt equity ratio can’t be less than 0
Based on the equation above, we can easily calculate the debt ratio based on debt equity ratio.
Application
The concept of debt ratio can not only apply to individual company but also can apply to industry or sector level. If we use Stock Market Browser to investigate the debt equity ratio of 9 sectors, we see the sector Industrial Goods has the highest debt to equity ratio while Basic Material has the lowest debt to equity ratio.
We can apply Eq. 3 to calculate these two sectors’ debt ratio:
For sector industrial goods, its debt ratio = = 65.64%
For sector Basic Materials, its debt ratio = = 27.54%
