Short Definition

The debt to equity ratio (D/E) is a financial ratio indicating the relative proportion of equity and debt used to finance a company's assets. The higher the debt level, the more risk the company is taking. Watch for debt levels much higher than the industry. If the industry is the optimal level, then higher debt/equity ratios for particular companies will indicate additional risk for that particular company. Inversely, lower debt/equity ratio may indicate that the target companies returns could be better if they had more debt in their capital structure.

Long Definition

This ratio is also known as Risk, Gearing or Leverage. It is equal to total debt divided by shareholders' equity. The two components are often taken from the firm's balance sheet or statement of financial position (so-called book value), but the ratio may also be calculated using market values for both, if the company's debt and equity are publicly traded, or using a combination of book value for debt and market value for equity.

Preferred shares can be considered part of debt or equity. Attributing preferred shares to one or the other is partially a subjective decision but will also take into account the specific features of the preferred shares.

When used to calculate a company's financial leverage, the debt usually includes only the Long Term Debt (LTD). Quoted ratios can even exclude the current portion of the LTD. The composition of equity and debt and its influence on the value of the firm is much debated and also described in the Modigliani-Miller theorem.

Financial analysts and stock market quotes will generally not include other types of liabilities, such as accounts payable, although some will make adjustments to include or exclude certain items from the formal financial statements. Adjustments are sometimes also made to, for example, exclude intangible assets, and this will affect the formal equity; debt to equity will therefore also be affected.

Financial economists and academic papers will usually refer to all liabilities as debt, and the statement that equity plus liabilities equals assets is therefore an accounting identity (it is, by definition, true). Other definitions of debt to equity may not respect this accounting identity, and should be carefully compared.

Formula

D/E = Debt (Liabilities)/ Equity

(Sometimes only interest-bearing long-term debt is used instead of total liabilities in the calculation)

A similar ratio is debt-to-total assets (D/A), also known as debt-to-value:

D/A = debt / assets = debt / (debt + equity)

The relationships between D/E and D/A are:

D/A = D/E / (1 + D/E)

D/E = D/A / (1 – D/A)

In the financial industry (particularly banking), a similar concept is equity to total assets (or equity to risk-weighted assets), otherwise known as capital adequacy:

Capital Adequacy = E / A

Since D + E = A (by the accounting equation), D/A + E/A = 1, so E/A = 1 - D/A. For instance, if a company has 10% capital adequacy, they have 90% debt-to-assets.

Source: http://en.wikipedia.org/wiki/Debt_to_equity_ratio