What Is a Debt-To-Equity Ratio?

The debt-to-equity ratio is an important financial consideration for any company. Also known as the debt-equity ratio or risk ratio, this metric is used to determine a business’ leverage and evaluate the extent to which the company finances operations through its own funds rather than accruing debt.

In this article, we will delve deeper into what this ratio means for a company, explain how a debt-to-equity ratio formula is used and find out more about what is considered a good one for a company to have.

What Is the Debt-to-Equity Ratio?

D/E ratio is a leverage ratio, which compares total debts to shareholder equity. The debt-to-equity calculation provides an insight into how companies finance their operations. The ratio gives an accurate idea of how company capital is weighted. 

To calculate the debt-to-equity ratio, you must have figures for the total debt and the current shareholder equity. The debt-to-equity ratio formula provides valuable information about the relationship between company debt and shareholder equity.

As well as being beneficial for shareholders, this information is also crucial for potential investors who are analyzing the financial health of the business. 

In simple terms, the higher the debt-to-equity ratio, the more reliant the business is on debt to finance operations, but higher values don’t necessarily mean a red flag for every organization.

How To Calculate Debt-to-Equity Ratio

The debt-to-equity ratio formula works as follows:

Debt-to-Equity Ratio= Total Liabilities / Total Shareholder Equity

To calculate it, you must use data from corporate balance sheets. The balance sheet will provide you with figures for both company liabilities and shareholder equity. You can then use the formula to produce a sum from the total debt divided by total equity.

The balance sheet must ensure that the total shareholder equity is equal to total assets minus liabilities. This is expressed as Assets = Liabilities + Shareholder Equity.

In some cases, it is necessary to modify the D/E ratio because balance sheets can contain accounts that may be deemed ambiguous. By adjusting the ratio to negate earnings, losses and assets that can distort the figure, the calculation becomes more accurate and useful. 

Debt/equity ratio example:

To illustrate the D/E ratio better, here is an example calculation. If company A has a total debt of $50 million and total equity of $150 million, this means the debt-equity ratio is 0.33. This means that for every $1 the firm has in equity; it has $0.33 in leverage.

A ratio of 1 means that debt and equity are on even footing. A higher score means that the company is more reliant on debt than financing through equity. 

Why Is the Debt-to-Equity Ratio Important?

A company’s D/E ratio provides a measure of debt compared to equity. The most practical purpose of this calculation is to evaluate the extent to which the business is accruing debt to leverage assets.

A high debt-equity ratio indicates that a company is more aggressive when financing the business and funding growth via debt. 

While a high number may represent a higher risk, a ratio above 1 is not always a negative sign. There are complexities to consider, which means that it’s important to analyze figures for each company individually and evaluate the context in which it operates.

If, for example, a company uses debt to finance growth, it has the potential to earn more than it would have done without borrowing. If leverage increases above and beyond the cost of interest and debt, the shareholders will benefit.

In contrast, if the cost of the debt exceeds the value of the income generated through expansion, the share value is likely to drop. Changes in market conditions can impact debt costs, which means that it can be difficult to predict how the company will fare simply by looking at its D/E ratio.

Long-term debts and assets are likely to have more impact on the debt-equity ratio than short-term debts. Investors may prefer to use other ratios, including cash ratios, if they are keen to gauge short-term leverage. 

What Is a Good D/E Ratio?

This is a very difficult question to answer. That’s because there are several factors to consider when interpreting debt-to-equity ratios, including the type of business and the industry in which it operates. It is common to have higher debt-to-equity ratios in the banking and finance sector, for example. 

Generally speaking, higher debt-to-equity ratios are considered higher risk. A figure below 1.0 usually denotes low risk, while a number above 2.0 would be considered higher risk. 

It is worth noting that investors may be put off by both high and low figures. If the debt/equity ratio is very low, this may indicate that the company is failing to use leverage to develop the business and facilitate growth. 

What Does a D/E Ratio of 1.5 Mean?

If a company has a D/E ratio of 1.5, this means that the business has $1.50 worth of debt for every $1 of equity. 

What Does a Negative Debt-To-Equity Ratio Mean?

If a company has a negative D/E ratio, this means that business debt exceeds shareholder equity and has more liabilities than assets. 

What Are the Limitations of the D/E Ratio?

One of the most important things to be aware of when analyzing with this metric is the industry in which the company operates. It’s crucial to view figures in context and try to understand how the ratio compares to other organizations within the same sector.

In the finance industry and sectors like utilities, for example, it is common for debt-to-equity ratios to be relatively high. A lack of context can be a limitation when evaluating figures. 

Another potential limitation is a lack of consistency when defining debts and liabilities. Some analysts may view preferred stock as equity, but in some cases, a preferred dividend can look more like debt. 

When looking at a decreasing or increasing debt-equity ratio, it’s best to compare the figures with firms that operate within the same industry. This will give a more accurate idea of where the company stands.

A figure that is very different from most other firms is likely to raise eyebrows among potential investors. 

D/E Ratio Modifications

It is common to modify the D/E ratio to enable analysts and investors to concentrate on key risks. One problem is that on a balance sheet, shareholder equity equals the total value of assets minus liabilities.

This is not the same calculation as assets minus the debts that are linked to those assets. Adopting a long-term D/E ratio is often preferable. Short-term debts tend to be less risky because they are paid off faster.

This means that a company with higher short-term debts and lower long-term debts may be less risky than an organization with higher long-term and lower short-term debts, even if they both have the same D/E ratio.