Long term (LT) Debt to Equity ratio is calculated as the ratio of LT debt of the company to the shareholders equity of the company for the most recent financial year. Long term debt refers to the loan amount raised by the company, which is repayable at least only after a year. Shareholders equity is the sum of profits retained by the company and amount invested into the company by shareholders.
This ratio helps understand the extent to which the company is raising loans to fund projects.
Suppose the LT debt of the company is Rs.130 and shareholders equity is Rs.100, then LT debt equity ratio is 130/100 = 1.3 .
Interest expense is a fixed cost that has to be paid on loan / debt raised by the company. Higher the debt raised more the interest cost. So if the company funds projects using more of debt funds, interest expense automatically increases eating into profitability of the company. Hence, all other things remaining the same, company with lower long term debt to equity ratio is preferable compared to ones with higher ratio.
A company with decreasing trend in LT debt to equity ratio over the medium term will usually see improved profits and record higher ROE. LT debt to equity ratio of companies operating in the same sector can also be compared with each other.