Debt/equity ratio

Debt to equity is the commonest type of gearing ratio. There are three basic variations on this ratio:

  • long term debt ÷equity
  • total debt ÷equity
  • net debt ÷equity

All these numbers should be on the balance sheet. It may be necessary to look at the notes to separate debt from other liabilities.

Each of these can be further adjusted by including or excluding particular assets that it may not be prudent to include, most commonly goodwill.

Long term debt/equity is the most correct measurement if:

  • What you are interested in is a company's capital structure
  • All short term debt is genuine short term debt

The second qualification is necessary because it is possible for a company to have what is technically short term debt that is effectively long term debt: for example, an overdraft which, although it is payable on demand, is not paid off for several years. In this case it may be preferable to use total debt over equity.

As companies can use their cash (and short term investments) to pay off debt at short notice, it is common to subtract these from the amount of debt to give a better idea of solvency. This gives us the last definition.

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