Debt-to-equity ratio

What it means

The debt-to-equity ratio compares borrowed funds, mainly loans and borrowings, with a company's equity. It shows how many euros of debt there are for every euro the owners have put in and left in the business. The higher it is, the more the company relies on debt and the more sensitive it is to rising interest rates or falling sales.

It is one of the leverage indicators and describes the capital structure. Some calculations include only interest-bearing debt, others all liabilities including trade payables. When comparing, you need to know which definition was used, otherwise the conclusions will mislead.

Moderate debt can raise the return on equity through financial leverage, as long as the company earns more on borrowed money than it pays for it. Excessive debt, however, increases the risk that in a bad year the company cannot repay and loses control to its creditors.

How it works in practice

Banks often write covenants into loan agreements, such as a maximum debt-to-equity or net debt to EBITDA ratio. Breaching them can trigger penalties or early repayment, so the ratios should be monitored continuously, not only at year end.

In small companies, loans from shareholders distort the picture. Economically they often behave like equity, but in the accounts they are liabilities. A bank may treat them as subordinated debt if the shareholder undertakes not to demand repayment before the bank loan is repaid.

The ratio is always judged together with the ability to service debt, for example interest coverage or the ratio of repayments to cash flow. A company with high but stable cash flow can carry more debt than one with volatile sales, even at the same ratio.

What to watch out for

Negative equity makes the ratio meaningless and is a serious warning sign in itself. After prolonged losses a company may fall into crisis under the Commercial Code, with special restrictions on repaying shareholder loans and duties for the director.

Industries differ widely. Capital-intensive firms, for example in energy or real estate, routinely operate with higher ratios, asset-light service firms with lower ones. Comparisons make sense only among similar companies and over time.