Debt/Equity Ratio
The debt/equity ratio measures risk from the perspective of both the company and existing and potential lenders. The primary risk to the company is that both principal and interest payments on debt are fixed costs. They must be paid even if the company’s business and its cash flow decline. The other risk to the company is that if its ratios decline, it may violate its loan agreements. This might trigger higher interest rates or, worse, calling of the loan.
Long-Term Debt / Stockholders’ Equity = Debt/Equity Ratio
Short-term bank debt is also a source of risk. Repayment of this debt is also a fixed cost, and its due date is more immediate than that of long-term debt. Remember that short-term debt is due in less than one year. Some analysts redefine the debt/equity ratio to include bank debt, as follows:
(Bank Debt + Long-Term Debt) / Stockholders’ Equity = Funded Debt / Stockholders’ Equity
Funded debt refers to funds of all maturities borrowed from financial institutions. For most manufacturing companies, a debt/ equity ratio of more than 0.5 is perceived to be on the borderline of being risky. This would not be true if the company were a public utility or a very high-quality commercial real estate company. For manufacturing or service businesses, a funded debt/ equity ratio in excess of 0.6 or 0.7 to 1 is interpreted as definitely approaching the risky stage.