Which Financial Ratio Reflects Capital Structure?

When analyzing the financial health and growth potential of a company, business owners and investors look to financial ratios that indicate how a company is funded and how effectively those dollars are being used. In ratio analysis, the debt to equity ratio is widely considered the best reflection of a company’s capital structure.

Debt to Equity Ratios

As the name implies, the debt to equity ratio compares a company’s total liabilities to its total equity financing. A high debt to equity ratio indicates that a business receives a much greater proportion of its capital funding from lenders rather than shareholders. However, a large amount of debt is generally considered a sign of risky business practices; payments on that debt are required by law regardless of business revenues. A company with a high debt to equity ratio that experiences a financial downturn must continue to make payments on its debts even if the business fails to generate enough revenue to cover them; this can quickly lead to loan default and bankruptcy. Generally, a lower debt to equity ratio is preferred by both investors and lenders.

Debt Financing

On the other hand, debt financing allows a company to leverage existing capital to fund expansion at an accelerated rate. A debt to equity ratio of 0 (indicating no debt financing) is a sign that the company is potentially missing out on important opportunities to grow the business. A growing business means increased profits for both owners and shareholders, so a company that ignores debt financing entirely may be doing a disservice to its investors. The debt to equity ratio offers concrete information about the balance of a company’s capital funding and the relative risk of its business model.

The optimal balance of debt and equity varies from business to business and industry to industry, so the debt to equity ratio is best used as a comparative metric between companies in the same sector. To ensure a comprehensive financial analysis, the individual business’s operational model, profitability metrics, and historical performance must all be considered when looking at the debt to equity ratio.