A lower Debt to Equity Ratio implies a more financially stable business. Those with a high ratio use more creditor financing (bank loans and leases) than investor financing (shareholders) to invest in their business.
Overview
Debt to Equity Ratio is a Solvency Ratio that identifies the percentage of business financing that comes from creditors and investors. A company is viewed as risky when its Debt to Equity Ratio is greater than one. This shows that creditors, rather than investors, have been funding operations.
The higher the Debt to Equity Ratio, the greater the risk to a creditor. A lower ratio generally indicates greater long-term financing ability. If Net Worth is negative, the resulting ratio will be negative. A Debt to Equity Ratio is considered favorable if it equals Risk Management Agency (RMA) standards, or at least 1:1.
The formula for calculating the Debt to Equity or Debt to Net Worth Ratio
Total Liabilities / Total Equity
A Debt to Equity Ratio of 1 means that investors and creditors have an equal stake in the business assets. A ratio of 2-to-1 indicates a highly leveraged company, where monies owed are two times greater than owners’ equity in the company.
Lower is Better: a lower debt to equity ratio implies a more financially stable business.
Higher is Worse: indicates that more creditor financing (bank loans and leases) is used, rather than investor financing (shareholders).