The Debt/Equity ratio is important for investors to calculate since it helps them predict how much assurance they have if a company becomes insolvent. In a case of bankruptcy, a company must always pay off its debtors before it can pay off its shareholders; therefore this ratio indicates how much of shareholders equity would be required to pay off a company's creditors. The lower the ratio, the better it is for investors.
Debt to Equity Ratio: Total Liabilities / Common Stockholders Equity
Example:
Adequate Disclosure, Inc. is planning on investing into Inadequate Disclosure, Inc. One formula the financial analysts for Adequate Disclosure, Inc. decide to use to judge their investment decision is the debt/equity ratio. The industry average is 3.0. The following balance sheet is for Inadequate Disclosure:
Should Adequate Disclosure, Inc. invest into Inadequate Disclosure, Inc.?
Debt/Equity Ratio: Total Liabilities / Common Stockholders Equity
1- 12,680,071 / 6,081,000 = 2.08
No Adequate Disclosure, Inc. should not invest into Inadequate Disclosure, Inc. since the Debt/Equity ratio is lower than the industry’s average. If Inadequate Disclosure becomes insolvent, may not have enough money to pay off its Shareholders in the future. Therefore Adequate Disclosure, Inc. should not invest into Inadequate Disclosure, Inc.