A financial ratio that measures the weight of debt financing in the capital structure (i.e., long-term sources of finance) of an entity. Differently put, it reflects the way an entity is financed: the ratio of borrowed funds (debt) to owners’ contributed funds (equity).

Debt is an interest bearing obligation that an entity has to pay interest on (irrespective of earnings), and repay its principal amount a certain time in the future. On the other hand, equity represents the shareholders’ contribution to capital for which they expect to receive profits/ earnings (in the form of distributed profits or dividends) or accumulate additional equity (in the form of retained earnings and reserves, etc.)

In general, and with everything else held constant, the cost of debt is lower than the cost of issuing shares since debt interest has certain tax deductions that are not available in the case of dividends paid to equity holders. The optimal debt-equity ratio is one that minimizes the cost of funding, i.e., the level at which the total cost of deb-equity combination is the  least among available funding options:

Where:

Total cost = (debt capital × cost of debt%) + (equity capital × cost of equity%)

This mix is also known as the debt-equity mix, debt to equity ratio (or simply, D/E ratio), risk ratio, or gearing/ leverage ratio.