Basic Formula

• The formula for determining the debt-to-equity ratio is relatively simple: You divide the company's debt, both short-term and long-term, by its equity, or shareholder value. This determines the ratio of liquidity, or leverage. Translate this to your own finances by looking at it this way; You make $1,000 per month, and you owe your creditors $500 per month. This leaves you a liquidity fund at the end of each month of $500, or a .50 debt-to-equity ratio ($500 divided by $1,000). The debt-to-equity ratio tells you how much in operating funds a company has available to handle unexpected expenses or, longer term, how much of the company's cash flow is tied up paying debt.
  
  

Normal Ratio

• The range of what is considered a normal debt-to-equity ratio can vary by industry. Some industries use more operating capital because they need to buy more materials to produce their product or service. For example, construction companies must purchase a lot of building materials, and they usually carry the cost of these materials (debt) until the finished product is sold. The debt-to-equity ratio in this industry can vary from 1.3 to 2.4 on the very high end. In contrast, a company such as an advertising agency or a consulting company does not have to buy many materials; these companies rely on their human capital, and they should have a lower debt-to-equity ratio. That ratio would be in the range of .65 to .8. Researching each industry gives you a view of a normal range for that particular type of company.
  
  

The Importance of the Ratio

• All companies carry debt, and sometimes a company carries a lot of debt for a short time to finance growth. As a result, a company might have a high debt-to-equity ratio for a relatively brief period, and then the ratio might come down once the growth begins to be realized. However, if a company consistently has a high debt-to-equity ratio over a long time, this suggests that the company has borrowed heavily but its growth has not been able to keep up with its debts. This can indicate a company is overleveraged and might not be able to meet its long-term obligations.
  
  According to Buffettsecrets, famous investor Warren Buffett steers clear of companies with too much long-term debt, because he believes it increases their interest expenses and gives them an unpredictable future cash flow.
  
  

Where to Find the Ratio

• Publicly traded companies release reports on their finances at least quarterly; you can request these reports by mail from the company. You also usually can link to a company's financials from its website. To determine equity, multiply the number of shares outstanding by the price per share. For example, if a company has 100 shares outstanding and the shares are selling for $1 per share, the company's equity is $100. The company's debts or liabilities should be listed in its financials; add the long-term and the short-term debt. Divide the debt by the equity, and the resulting number is the ratio.
  
  

The Bottom Line

• The debt-to-equity ratio is one of the key indicators of any company's ability to get the credit required to operate, grow and return a profit. This ratio can shift regularly, and should show a pattern of ups and downs indicating periods of investment and growth followed by returns on that growth and a higher cash flow (liquidity) and leverage ability.