Debt-to-Equity Ratio
Debt-to-Equity Ratio
A financial leverage metric calculated as Long-term Debt divided by Total Capitalization (D/E = Long-term Debt ÷ Total Capitalization, where Total Capitalization = Long-term Debt + Shareholders' Equity). Measures the proportion of long-term debt financing relative to permanent capital. Short-term debt is excluded. Higher ratios indicate greater financial leverage, which amplifies both potential gains and losses for equity holders.
Company A has $50 million in long-term debt and $100 million in shareholder equity, giving total capitalization of $150 million. D/E ratio = $50M ÷ $150M = 0.33 (33% debt-financed). Company B has $80 million in long-term debt and $40 million in equity, giving total capitalization of $120 million. D/E ratio = $80M ÷ $120M = 0.67 (67% debt-financed). Company B is more highly leveraged, meaning it uses more long-term debt financing relative to permanent capital, which increases both potential returns to shareholders and financial risk.
Students often confuse whether high D/E is "good" or "bad." High leverage magnifies returns when business performs well (good for shareholders) but also magnifies losses and increases bankruptcy risk when business struggles (bad). Also critical: D/E uses LONG-TERM debt only (excludes short-term debt like accounts payable), and the denominator is TOTAL CAPITALIZATION (long-term debt + equity), not just equity. Industry context matters: utilities typically have higher D/E ratios while tech companies often have lower ratios.
How This Is Tested
- Calculating debt-to-equity ratio using long-term debt divided by total capitalization (long-term debt + equity)
- Identifying which debt to include (long-term only, excluding short-term obligations)
- Comparing leverage between companies to identify which has greater financial risk
- Understanding how leverage ratios amplify both gains and losses for equity investors
- Recognizing industry variations in typical D/E ratios (capital-intensive vs. asset-light businesses)
Regulatory Limits
| Description | Limit | Notes |
|---|---|---|
| Debt-to-Equity Ratio Formula | Long-term Debt ÷ Total Capitalization | Total Capitalization = Long-term Debt + Shareholders' Equity. Short-term debt is excluded from this ratio calculation. Measures permanent capital structure. |
Example Exam Questions
Test your understanding with these practice questions. Select an answer to see the explanation.
Marcus, a conservative investor, is comparing two manufacturing companies in the same industry. Company X has a debt-to-equity ratio of 0.40, while Company Y has a debt-to-equity ratio of 1.80. Both companies have similar revenue and profitability. Marcus is concerned about downside risk during economic downturns. Which statement best describes the relationship between leverage and risk for these companies?
B is correct. Company X, with a D/E ratio of 0.40, uses significantly less debt financing relative to equity compared to Company Y (D/E of 1.80). During economic downturns, companies with lower leverage have less mandatory debt service (interest and principal payments), making them more resilient when revenues decline. For a conservative investor like Marcus concerned about downside protection, lower leverage reduces financial risk.
A is incorrect because higher D/E ratios indicate MORE financial risk, not stronger health, particularly during economic stress. C is incorrect because leverage levels create different risk profiles even within the same industry. D is incorrect because while debt interest is tax-deductible, this benefit does not make high leverage "preferable" for conservative investors focused on downside risk; the amplified losses during downturns outweigh tax benefits for risk-averse investors.
The Series 65 exam tests your ability to evaluate financial leverage and match securities to client risk tolerance. Understanding that debt-to-equity ratios measure financial risk is critical for suitability determinations and fundamental analysis of equity investments.
What does a debt-to-equity ratio of 1.50 indicate about a company's capital structure?
B is correct. A debt-to-equity ratio of 1.50 means the company has $1.50 in total debt for every $1.00 in shareholder equity. The formula is D/E = Total Debt ÷ Equity, so a ratio of 1.50 indicates debt is 1.5 times larger than equity. For example, a company with $150 million in debt and $100 million in equity has a D/E of 1.50.
A is incorrect because it reverses the ratio (that would be an equity-to-debt ratio of 0.67, not D/E of 1.50). C is incorrect because D/E compares debt to equity, not assets to liabilities (that would be a leverage ratio or debt ratio). D is incorrect because D/E is a snapshot ratio at a point in time, not a measure of change over time.
The Series 65 exam frequently tests your ability to interpret financial ratios correctly. Understanding what D/E ratios actually measure prevents confusion between leverage metrics and ensures accurate fundamental analysis.
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Access Free BetaA company has long-term debt of $60 million, short-term debt of $15 million, and shareholder equity of $80 million on its balance sheet. What is the company's debt-to-equity ratio?
A is correct. Calculate debt-to-equity ratio using the formula: D/E = Long-term Debt ÷ Total Capitalization
Step 1: Identify long-term debt (short-term debt is NOT included):
Long-term Debt = $60 million
Step 2: Calculate total capitalization:
Total Capitalization = Long-term Debt + Equity
Total Capitalization = $60 million + $80 million = $140 million
Step 3: Calculate D/E ratio:
D/E = $60 million ÷ $140 million = 0.43 (or 43%)
This means 43% of the company's permanent capital structure is financed by long-term debt, while 57% is equity-financed. The short-term debt ($15M) is excluded because D/E measures permanent capital structure, not total liabilities.
B (0.54) results from incorrect calculations. C (0.75) incorrectly adds short-term debt to get $75M total, then divides by equity alone ($75M ÷ $100M)—wrong on both counts. D (0.94) results from calculation errors.
The Series 65 exam tests whether you know to EXCLUDE short-term debt from the debt-to-equity calculation. This ratio measures permanent capital structure using only long-term debt divided by total capitalization (long-term debt + equity). Understanding this distinction is critical for accurate fundamental analysis.
All of the following statements about debt-to-equity ratios are accurate EXCEPT
C is correct (the EXCEPT answer). A D/E ratio above 1.0 does NOT always indicate poor financial health or mean the investment should be avoided. Appropriate D/E ratios vary dramatically by industry: utilities and capital-intensive businesses commonly operate with D/E ratios of 2.0 or higher due to stable cash flows supporting debt service, while technology companies might have D/E ratios below 0.5. Context and industry norms matter more than absolute thresholds.
A is accurate: financial leverage magnifies returns in both directions (higher gains when business succeeds, larger losses when it struggles). B is accurate: companies with more debt have fixed interest and principal obligations that become burdensome when revenues decline during recessions. D is accurate: comparing D/E ratios requires industry context because capital structure norms differ across sectors based on asset intensity, cash flow stability, and business models.
The Series 65 exam tests your ability to avoid oversimplified rules of thumb when analyzing financial statements. Understanding that leverage must be evaluated in industry context demonstrates sophisticated fundamental analysis skills needed for appropriate suitability recommendations.
An analyst is comparing two retail companies. Company A has long-term debt of $200 million and equity of $300 million. Company B has long-term debt of $150 million and equity of $100 million. Which of the following statements are accurate?
1. Company A has a debt-to-equity ratio of 0.40
2. Company B is more highly leveraged than Company A
3. Company B would likely experience greater earnings volatility due to higher financial leverage
4. Lower leverage would increase Company A's ROE
C is correct. Statements 1, 2, and 3 are accurate.
Statement 1 is TRUE: Company A D/E = Long-term Debt ÷ Total Capitalization = $200M ÷ ($200M + $300M) = $200M ÷ $500M = 0.40 (40% debt-financed).
Statement 2 is TRUE: Company B D/E = $150M ÷ ($150M + $100M) = $150M ÷ $250M = 0.60 (60% debt-financed). Company B's ratio of 0.60 is higher than Company A's 0.40, meaning Company B is more highly leveraged.
Statement 3 is TRUE: Higher financial leverage (Company B's 0.60 vs Company A's 0.40) amplifies earnings volatility because fixed debt service (interest payments) magnifies the impact of revenue changes on net income available to equity holders.
Statement 4 is FALSE: Lower leverage would DECREASE ROE, not increase it. Leverage amplifies returns to equity holders by reducing the equity base (denominator in ROE = Net Income ÷ Equity). Less debt means more equity capital, which reduces ROE when earnings are positive.
The Series 65 exam tests your ability to calculate debt-to-equity using the correct formula (long-term debt ÷ total capitalization) and compare leverage ratios across companies while understanding implications for earnings volatility and ROE. This multi-step analysis is essential for suitability determinations.
💡 Memory Aid
Think of D/E as a financial seesaw: More debt (left side) amplifies the ups and downs for equity holders (right side). High D/E = High-wire act - greater rewards when things go well, harder fall when they don't. Formula: Debt ÷ Equity.
Related Concepts
This term is part of this cluster: