'Debt to Equity' is explained in detail and with examples in the Corporate Finance edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
Debt to Equity refers to a ratio that is extremely important and often scrutinized in the world of business. It is the amount of longer term debt on the balance sheet of a corporation as related to and divided by the company equity. Long term debt for a company means money that it will not be expected to pay back in the coming 12 months. Both are critical factors in effective balance sheet analysis.
This ratio tells an analyst or investor a great deal about a company and the amount of debt it is carrying compared to its true net worth. This is accomplished by gathering together all of the company liabilities and then dividing this amount up by the shareholder equity. The end result which comes back in dividing the total debt by the equity proves to be the percentage of the firm which is leveraged (or more accurately stated— indebted).
Over time, the acceptable and average amount of debt to equity has varied significantly in the corporate world. Today it heavily depends on both the state of the economy, the industry in which the company operates, and the all-around feelings of society concerning credit and debt. If all else is equal, any firm with a debt to equity ratio in excess of 40 percent to 50 percent should be more careful about the risk hidden within its balance sheet and books. These could lead to a liquidity crisis at some point in the future.
When analysts consider the working capital of the company and find that both it and the current ratios of the firm are dramatically low, then this is a glaring sign of significant financial weakness in a corporation. This is why an analyst or investor truly needs to adjust any current profitability numbers to the economic cycle at hand. Many investors have lost fortunes over the years because the plugged in peak earnings at the height of an economic boom as their base case scenario metric for a firm’s ability to pay back its various debt obligations.
There is no good reason to fall for this age old trap after all. All that is required to avoid it is to predict that the economy may fall off a proverbial cliff at any point and time. Then consider if the cash flow would be sufficient to cover the liabilities without the corporation being hurt and hampered by a lack of money for critical daily, monthly, and yearly expenses on items such as plant, property, and equipment.
The truth is that debt and elevated debt to equity ratios is not necessarily a bad thing. Many businesses are quite adept at earning a greater return on their capital than the cost of the interest which they incur in borrowing the money. This would make it extremely profitable to borrow money in such cases. It allows such firms to boost their earnings and profitability for one thing. The real key element is that the company management clearly understands the level of debt which will represent a danger level for smart and forward thinking stewardship of their company. Leverage cuts both ways. It dramatically boosts returns when it is working well for a firm, and it similarly can even totally wipe out a company if things turn on the firm in an economic recession or even economic depression.
Investors especially need to be careful in buying corporate bonds in such environments. Bonds issued in the lower interest rate environments of today will suffer drastically when the interest rates invariably rise higher, especially if this is quick and unexpected. This will lead to less profitability for the firm when the bonds have to be financed again. If the management did not wisely prepare for such an issue well in advance, then the company will truly have been mismanaged during the golden boom days and will suffer needlessly during the inevitable bust economic times.