What Is the Debt-to-Equity Ratio (D/E)?
The debt-to-equity ratio (D/E) is an essential formula in corporate finance. It’s used to measure leverage (or the amount of debt a company has) compared to its shareholder equity.
All companies have a debt-to-equity ratio, and investors and analysts actually prefer to see a company with some debt. Debt can be used to help companies finance activities that lead to long-term growth.
Another way to think about this ratio is to think of debt as the amount of capital contributed by creditors, compared to the amount of capital contributed by shareholders (equity). Lenders want to see just how much a company owes others (debts) versus how much capital is available.
Is a Low Debt-to-Equity Ratio Better?
Lenders and investors usually prefer low debt-to-equity ratios because their interests are better protected in the event of a business decline. Thus, firms with high debt-to-equity ratios may not be able to attract additional capital (equity). If a company owes too much, it may not be able to take on more debt or obtain additional capital from shareholders.
The video below offers more insight into what the debt-to-equity ratio measures and how it can be used to assess a company’s potential as an investment.
Should Your Debt-to-Equity Ratio be High or Low?
Although it may seem that a lower debt-to-equity ratio is more desirable, it’s not always practical. Some industries require a significant investment in equipment and infrastructure to conduct business. This pushes their debt higher than other industries that borrow less to finance their activities.
Analysts, investors, and lenders use industry benchmarks to assess whether a company’s debt-to-equity ratio is high or low. These benchmarks provide the relevant industry average. The debt-to-equity ratios of comparable companies (within the same industry) provides additional context to judge whether the ratio is acceptable, too high, or too low.
How to Calculate Debt-to-Equity Ratio
The numbers needed to calculate the debt-to-equity ratio may be found on a company balance sheet. You’ll need to know:
The total liabilities
The total shareholder equity
Liabilities are what the company owes others. Shareholder’s equity is the company’s book value (or the value of the assets minus its liabilities) from shareholders’ contributions of capital.
A D/E ratio greater than 1 indicates that a company has more debt than equity. A D/E ratio less than 1 indicates that a company has more equity than debt.
The Debt-to-Equity Ratio Formula
The debt-to-equity ratio calculation is as follows:
Debt-to-Equity Ratio Example
Look at the balance sheet, below.
What’s a Good Debt-to-Equity Ratio?
Investors typically look for a D/E ratio that is around the middle of the average industry range. Industry benchmarking sites provide the average ratio for a wide range of industries each year.
Industries that tend to have low debt-to-equity ratios:
Industries with higher debt-to-equity ratios tend to invest more heavily in infrastructure and equipment to deliver their products and services.
Industries that tend to carry higher debt-to-equity ratios include:
Finance and banking
Railroads, for example, take on higher debt to pay for the equipment necessary to deliver their services. A new diesel locomotive costs $500,000 to $2 million. If a railroad must replace several locomotives per year or wishes to add to its fleet, it may need to take on debt, which can increase its debt-to-equity ratio.
What’s a Negative Debt-to-Equity Ratio?
A negative debt-to-equity ratio results when a company has negative equity, which would happen if the book value of its shareholders’ capital has been eroded by losses (negative profits). If the company is unable to earn profits (and earns losses instead), it may be unable to pay back its debt.
Analysts will require further research to understand the situation and its implications before judging whether a negative debt-to-equity ratio is worrisome or not.
Limitations of the Debt-to-Equity Ratio
As with all financial metrics, debt-to-equity ratio is only part of the whole picture. By itself, a low debt-to-equity ratio may not mean that a company is a good potential investment.
Consider a tech company with a D/E ratio of 0.34 (which is lower than the industry benchmark of 0.56). It may seem like a good potential investment, but the company may be missing growth opportunities by avoiding debt. Reading through their entire annual report – and conducting further research – will provide a far clearer picture. For example, if a company took on debt for expansion purposes, their debt-to-equity ratio may be high this year, but it may be a positive sign of growth.
Lastly, capital-intensive industries (with high debt-to-equity ratio) may be a good investment after considering all factors. While the debt-to-equity ratio is a useful measure, it’s only one among many that investors and analysts consider before judging a company’s potential as an investment.
Why Is the Debt-to-Equity Ratio Important?
Generally, a high debt-to-equity ratio indicates that a company may not be able to generate enough cash to satisfy its debt obligations. However, low debt-to-equity ratios may also indicate that a company is not taking advantage of the increased profits that financial leverage may bring.
It’s important to remember that the comparison of debt-to-equity ratios is generally most meaningful among companies within the same industry, and the definition of a "high" or "low" ratio should be made within this context.
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