Key Takeaways
- The ratio divides total liabilities by total equity; a result above 2.0 generally signals high leverage for industrial companies, though acceptable levels vary by sector.
- Lenders frequently embed debt-to-equity covenants in loan agreements, and a breach can reclassify non-current borrowings to current under IAS 1.74.
- Auditors use the ratio during analytical procedures (ISA 520) to identify unexpected shifts in the capital structure between periods.
- A deteriorating debt-to-equity trend is one of the financial indicators ISA 570.A3 lists when evaluating whether a going concern doubt exists.
What is Debt-to-Equity Ratio?
IAS 1.134 requires an entity to disclose information that enables users to evaluate its objectives, policies, and processes for managing capital. The debt-to-equity ratio sits at the centre of that disclosure. In practice, the ratio is calculated as total liabilities divided by total shareholders' equity, though some practitioners restrict the numerator to interest-bearing debt only. The version used depends on the loan covenant or the analytical purpose, so the auditor checks which definition management applies and whether it is consistent with prior periods.
ISA 520.5 requires the auditor to design and perform analytical procedures as risk assessment procedures. A year-on-year spike in the debt-to-equity ratio flags a potential risk of material misstatement in the classification of liabilities, the completeness of borrowing disclosures, or the going concern assessment under ISA 570. The ratio alone does not answer any of these questions. It tells the auditor where to look. IAS 1.135(d) requires disclosure of whether the entity complied with externally imposed capital requirements during the period, and if it did not, the consequences of non-compliance. When a covenant breach has occurred, IAS 1.74 may force reclassification of the entire loan from non-current to current, which reshapes the balance sheet.
Worked example: Rossi Alimentari S.p.A.
Client: Italian food production company, FY2025, revenue €67M, IFRS reporter. Rossi carries total liabilities of €44M (of which €30M is interest-bearing bank debt) and total equity of €23M at 31 December 2025. Its primary bank facility contains a covenant requiring the debt-to-equity ratio (defined as total liabilities divided by total equity) to remain below 2.5 at each reporting date.
Step 1 — Calculate the ratio: Total liabilities of €44M divided by total equity of €23M produces a debt-to-equity ratio of 1.91. The covenant threshold is 2.5. Rossi is in compliance with headroom of 0.59.
Documentation note: record the numerator and denominator as extracted from the trial balance, the covenant definition from the loan agreement, the calculated ratio, and the compliance conclusion. Cross-reference to the signed facility agreement on file.
Step 2 — Perform analytical comparison: In FY2024, Rossi's ratio was 1.62 (total liabilities €38M, equity €23.5M). The increase from 1.62 to 1.91 reflects €6M of additional borrowings drawn to fund a new packaging line. Compare this movement to management's explanation and to the capital expenditure records. ISA 520.A7 requires the auditor to develop an expectation of the ratio based on known changes in the business.
Documentation note: record the prior-year ratio, the current-year ratio, the expected movement based on known borrowings, and the conclusion on whether the change is consistent with expectations. Flag any unexplained variance for further investigation.
Step 3 — Assess going concern implications: Although the ratio increased, Rossi remains well within the covenant threshold. Cash flow from operations for FY2025 was €8.2M, covering annual debt service of €3.6M by a factor of 2.3. No other ISA 570.A3 indicators (operating losses, negative working capital, inability to pay creditors on due dates) are present. The ratio movement does not trigger a going concern doubt.
Documentation note: record the debt service coverage alongside the debt-to-equity ratio. Document the ISA 570.A3 indicator assessment and the conclusion that no material uncertainty exists regarding going concern.
Step 4 — Evaluate capital disclosure: IAS 1.134 requires Rossi to disclose its capital management objectives and the policies it follows. IAS 1.135 requires quantitative data on what the entity manages as capital, whether it complied with externally imposed capital requirements, and the consequences of any non-compliance. Rossi's draft note states the covenant threshold and confirms compliance. Verify the note includes all four elements of IAS 1.135(a)–(d).
Documentation note: map the disclosure to IAS 1.135(a)–(d). Confirm the covenant ratio in the note matches the ratio computed from the financial statements. Cross-reference to the bank confirmation letter for third-party corroboration of the covenant terms.
Conclusion: the debt-to-equity ratio of 1.91 is defensible because the numerator and denominator tie to the audited balance sheet, the covenant definition matches the loan agreement, the year-on-year movement is explained by documented capital expenditure borrowings, and the capital disclosure satisfies IAS 1.134–136.
What reviewers and practitioners get wrong
- Teams accept management's covenant compliance calculation without independently recomputing the ratio from the financial statements. The loan agreement sometimes defines "debt" or "equity" differently from the IFRS balance sheet (excluding lease liabilities under IFRS 16, for instance, or including subordinated loans in equity). ISA 520.5 requires the auditor to develop an independent expectation. Using management's spreadsheet as both the source and the test is not a procedure.
- When a covenant breach occurs between the reporting date and the date the financial statements are authorised for issue, teams sometimes overlook the IAS 10.22 disclosure requirement. If the breach constitutes a non-adjusting event after the reporting period, the entity must disclose its nature and estimated financial effect. Failing to do so leaves a gap in the notes that reviewers flag during engagement quality review.
Related terms
Frequently asked questions
What debt-to-equity ratio triggers a going concern risk?
No single threshold exists. ISA 570.A3 lists financial indicators (including net liability positions and adverse key financial ratios) as events or conditions that may cast doubt on going concern. The auditor evaluates the ratio in context: a 3.0 ratio may be normal for a real estate holding company but alarming for a manufacturing firm. Sector benchmarks, covenant headroom, and cash flow adequacy matter more than an absolute number.
Does IFRS require disclosure of the debt-to-equity ratio specifically?
No. IAS 1.134–136 requires capital management disclosures but does not mandate any specific ratio. The entity chooses which ratios and metrics present its capital structure. If a loan covenant references the debt-to-equity ratio, IAS 1.135(c)–(d) requires disclosure of compliance status and any consequences of non-compliance. The auditor checks that the chosen disclosures are consistent with the actual capital management approach.
How do IFRS 16 lease liabilities affect the debt-to-equity ratio?
IFRS 16 brought operating leases onto the balance sheet as lease liabilities, increasing total liabilities for lessees. This mechanically raises the debt-to-equity ratio. Many loan covenants negotiated before 2019 exclude IFRS 16 liabilities from the definition of debt, creating a difference between the IFRS balance sheet ratio and the covenant ratio. The auditor verifies which definition applies under the specific loan agreement and tests both calculations where they differ. ISA 520.A4 requires that the data underlying the analytical procedure is reliable for the purpose used.