Debt-to-Equity Ratio Explained with Pictures

Beyond assessing different characteristics of debt as just described, we want to know the level of debt, especially in relation to total equity. Such knowledge helps us assess the risk of a company’s financing structure. A company financed mainly with debt is more risky because liabilities must be repaid—usually with periodic interest—whereas equity financing does not. A measure to assess the risk of a company’s financing structure is the debt-to-equity ratio Defined as total liabilities divided by total equity; shows the proportion of a company financed by non-owners (creditors) in comparison with that financed by owners. (see Exhibit 14.15).

EXHIBIT 14.15 Debt-to-Equity Ratio

The debt-to-equity ratio varies across companies and industries. Industries that are more variable tend to have lower ratios, while more stable industries are less risky and tend to have higher ratios. To apply the debt-to-equity ratio, let’s look at this measure for Cedar Fair in Exhibit 14.16.

EXHIBIT 14.16 Cedar Fair’s Debt-to-Equity Ratio

Cedar Fair’s 2009 debt-to-equity ratio is 15.8, meaning that debtholders contributed $15.8 for each $1 contributed by equityholders. This implies a fairly risky financing structure for Cedar Fair. A similar concern is drawn from a comparison of Cedar Fair with its competitors, where the 2009 industry ratio is 11.4. Analysis across the years shows that Cedar Fair’s financing structure has grown increasingly risky in recent years. Given its sluggish revenues and increasing operating expenses in recent years (see its annual report), Cedar Fair is increasingly at risk of financial distress.