Debt-to-Equity Ratio Explained

The debt-to-equity ratio divides a company’s total debt by its shareholders’ equity, showing how much it relies on borrowing versus owners’ capital to fund itself. A ratio of 1 means equal amounts of each. Higher ratios mean more financial risk, because debt must be repaid whatever happens, but the right level depends heavily on the industry and the stability of the business.

Debt is a tool. Used well, it lets a good business grow faster and reward its owners. Used badly, it turns an ordinary downturn into a crisis. The debt-to-equity ratio is one of the oldest and quickest ways to see how heavily a company leans on that tool.

Where this fits: debt-to-equity is a measure of financial risk under Criterion 4, a sound balance sheet, in the Five Criteria framework. The Criterion 4 hub is long-term debt explained, and this guide pairs with the interest coverage ratio, which measures the burden rather than the size of debt.

What the Ratio Measures

A company funds its assets in two ways: with money it borrows (debt) and with money that belongs to its owners (equity). The debt-to-equity ratio compares the two.

Debt-to-equity = Total debt ÷ Shareholders’ equity

• Total debt is interest-bearing borrowing: short-term loans, long-term loans, bonds and, for many analysts, lease obligations. It is not the same as total liabilities, which also include things like trade payables and deferred tax.
• Shareholders’ equity is what would be left for owners if the company sold its assets and paid off all its liabilities: total assets minus total liabilities. You will find it at the foot of the balance sheet.

A ratio of 0.5 means the company has 50p of debt for every £1 of equity. A ratio of 2 means £2 of debt for every £1 of equity, a far more leveraged position.

A note on definitions

Not everyone calculates it the same way. Some use total liabilities instead of just interest-bearing debt, which produces a higher number. Others use net debt (debt minus cash). When you compare companies or read someone else’s figure, check which definition is in use. For a cautious, like-for-like view, I use interest-bearing debt in the numerator and note separately how much cash the company holds.

Why Leverage Cuts Both Ways

Debt magnifies returns on equity. Because borrowed money funds part of the assets, the profit those assets earn is spread over a smaller slice of owners’ capital. In good times, a leveraged company can show a higher return on equity than an unleveraged one.

The catch is that debt must be serviced and repaid regardless of how the business is doing. Interest is due in a recession just as in a boom. Equity, by contrast, absorbs losses; it is patient capital with no fixed claim. The more debt in the mix, the less room there is for things to go wrong.

This is the same amplifier we meet in operating leverage, but applied to the financing side. A company that stacks high financial leverage on top of high operating leverage has very little margin for error.

A Hypothetical Example

Imagine a company, Company A, with £1.2 billion of total assets. We will look at it under two financing structures to see how the ratio behaves. These are illustrative figures, not a real business.

	Conservative structure	Aggressive structure
Total assets	£1,200m	£1,200m
Total debt	£400m	£800m
Shareholders’ equity	£800m	£400m
Debt-to-equity ratio	0.5	2.0

Now suppose the business earns £120 million of operating profit, and borrows at 5%.

	Conservative	Aggressive
Operating profit	£120m	£120m
Interest (5% of debt)	£20m	£40m
Profit before tax	£100m	£80m
Interest coverage	6.0x	3.0x

In a good year, both survive comfortably, though the aggressive structure already fails our 5x interest coverage test. Now imagine operating profit falls by 40% to £72 million in a recession. The conservative company still covers its £20 million interest 3.6 times. The aggressive company’s £40 million interest now eats more than half its operating profit, leaving coverage of just 1.8x; one more bad year from real trouble. Same assets, same business, very different resilience. That difference is the debt-to-equity ratio made visible.

What Counts as a Healthy Level

There is no universal threshold, because the right level depends on how predictable the company’s cash flows are. A business with steady, contracted revenue can safely carry far more debt than a cyclical one.

Debt-to-equity	Broad interpretation
Below 0.5	Conservative; plenty of balance-sheet room
0.5 to 1.0	Moderate; comfortable for most stable businesses
1.0 to 2.0	Elevated; fine for utilities and infrastructure, watch others closely
Above 2.0	Aggressive; needs very stable earnings to justify

Industry context is everything:

• Utilities, pipelines and infrastructure run high ratios because their revenue is regulated or contracted and highly predictable.
• Banks and insurers sit outside this framework entirely; leverage is the nature of their business and they are judged on capital ratios instead.
• Property companies (REITs) carry large mortgages against their buildings, so high ratios are normal.
• Software, consumer brands and asset-light firms usually run low ratios because they need little borrowed capital and generate strong free cash flow.

Comparing a software firm’s ratio with a utility’s tells you nothing useful. Compare like with like, and compare the company with its own history.

Why the Ratio Can Mislead

The denominator, equity, is an accounting figure, and accounting can distort it badly.

• Share buybacks reduce equity. A company that buys back a lot of its own stock shrinks its equity base, which mechanically raises the debt-to-equity ratio even if its debt and cash generation have not changed. Stock buybacks can push equity close to zero or negative in extreme cases.
• Write-downs and goodwill can inflate or crater equity. A big acquisition adds goodwill that props equity up; a later impairment wipes it out, spiking the ratio overnight with no change in the real business.
• Accumulated losses erode equity over time, raising the ratio even as debt holds steady.

Because of these distortions, a negative or near-zero equity figure makes the ratio meaningless. When you see that, stop and ask why.

Why We Lean on Net Debt/EBITDA Instead

For these reasons, our primary leverage test under Criterion 4 is not debt-to-equity but net debt/EBITDA, with a house ceiling of about 2x. It compares debt (net of cash) with the earnings available to service it, which is closer to the economic reality of affordability.

Measure	What it answers	Main weakness
Debt-to-equity	How debt compares with owners’ capital	Equity is easily distorted
Net debt/EBITDA	How many years of earnings would clear the debt	EBITDA flatters capital-heavy firms
Interest coverage	How easily profit covers the interest bill	Ignores repayment of principal

None of these is sufficient alone. I read all three together, plus the debt maturity table in the notes, which the guide on reading the notes to the financial statements explains how to find. Debt-to-equity is a useful supporting view, especially for spotting a business whose equity has been hollowed out by buybacks or losses.

How to Use It in Practice

1. Calculate it with interest-bearing debt, not total liabilities, and note cash separately.
2. Compare it with industry peers and with the company’s own five-year trend. A ratio climbing year after year is worth investigating.
3. Check why equity is what it is. Heavy buybacks, goodwill or accumulated losses change how you should read the number.
4. Confirm with net debt/EBITDA and interest coverage. If all three agree, you have a clear picture. If they disagree, the reason is usually instructive.
5. Treat a negative ratio as a flag, not a figure. Find out what drove equity below zero before drawing any conclusion.

A consistently high and rising debt-to-equity ratio, paired with weak coverage, is one of the clearer red flags a balance sheet can show.

Frequently Asked Questions

What is a good debt-to-equity ratio?

There is no single answer, because it depends on the industry and the predictability of cash flows. As a broad guide, below 1 is conservative for most companies, 1 to 2 is moderate, and above 2 deserves scrutiny unless the business has very stable earnings. Utilities, banks and property companies routinely run higher; asset-light software and consumer firms usually run much lower.

How do you calculate the debt-to-equity ratio?

Divide total debt by total shareholders’ equity, both taken from the balance sheet. Total debt is usually short-term borrowings plus long-term borrowings; some analysts include leases. Shareholders’ equity is total assets minus total liabilities. A company with £400 million of debt and £800 million of equity has a debt-to-equity ratio of 0.5.

Can the debt-to-equity ratio be negative?

Yes, if shareholders’ equity is negative, which happens when accumulated losses or large buybacks push equity below zero. A negative ratio is not meaningful as a number and is a signal to stop and investigate why equity is negative. Sometimes it reflects heavy distress; sometimes it reflects a highly profitable firm that has bought back huge amounts of stock.

Why do we prefer net debt to EBITDA over debt-to-equity?

Because equity is an accounting figure that buybacks, write-downs and goodwill can distort, while EBITDA is closer to the cash the business produces to service its debt. Net debt/EBITDA asks how many years of earnings it would take to clear the debt, which is a more intuitive test of affordability. We use it as the primary leverage measure under Criterion 4.

Should leases be included in debt?

Under modern accounting standards most leases already appear on the balance sheet as liabilities, so they are often captured. For companies with large lease commitments, such as retailers and airlines, including leases gives a truer picture of their fixed obligations. If you exclude them, be consistent and note that you have done so when comparing companies.

Your Next Step

Calculate the debt-to-equity ratio for one company you follow, then check it against net debt/EBITDA and interest coverage to see whether the three agree. Read long-term debt explained for the full Criterion 4 test, learn to find the debt maturity table in reading the notes, and score the whole balance sheet with the Five Criteria Scorecard.

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About the author: Cameron Hayes is a senior investor relations and finance professional who has worked in IR at Nasdaq Copenhagen-listed companies including Nilfisk and Maersk Drilling. He holds an MSc from Copenhagen Business School and a BCom from the University of Ottawa, and founded Gingernomics to teach individual investors the Five Criteria framework. More about Gingernomics.

The content on Gingernomics is for educational and informational purposes only and does not constitute financial advice. Always do your own research and consult a licensed financial advisor before making any investment decisions. Past performance is not indicative of future results.