Debt-to-Equity D E Ratio: Meaning and Formula

In the banking and financial services sector, a relatively high D/E ratio is commonplace. Banks carry higher amounts of debt because they own substantial fixed assets in the form of branch networks. Higher D/E ratios can also tend to predominate in other capital-intensive sectors heavily reliant on debt financing, such as airlines and industrials.

Debt-financed growth may serve to increase earnings, and if the incremental profit increase exceeds the related rise in debt service costs, then shareholders should expect to benefit. However, if the additional cost of debt financing outweighs the additional income that it generates, then the share price may drop. The cost of debt and a company’s ability to service it can vary with market conditions. As a result, borrowing that seemed prudent at first can prove unprofitable later under different circumstances.

Which of these is most important for your financial advisor to have?

As a highly regulated industry making large investments typically at a stable rate of return and generating a steady income stream, utilities borrow heavily and relatively cheaply. High leverage ratios in slow-growth industries with stable income represent an efficient use of capital. Companies in the consumer staples sector tend to have high D/E ratios for similar reasons. Short-term debt also increases a company’s leverage, of course, but because these liabilities must be paid in a year or less, they aren’t as risky. Changes in long-term debt and assets tend to affect the D/E ratio the most because the numbers involved tend to be larger than for short-term debt and short-term assets. If investors want to evaluate a paid family leave company’s short-term leverage and its ability to meet debt obligations that must be paid over a year or less, they can use other ratios.

The opposite of the above example applies if a company has a D/E ratio that’s too high. In this case, any losses will be compounded down and the company may not be able to service its debt. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice.

Is an increase in the debt-to-equity ratio bad?

And, when analyzing a company’s debt, you would also want to consider how mature the debt is as well as cash flow relative to interest payment expenses. It’s also important to note that interest rate trends over time tax day trivia affect borrowing decisions, as low rates make debt financing more attractive. For companies that aren’t growing or are in financial distress, the D/E ratio can be written into debt covenants when the company borrows money, limiting the amount of debt issued.

In most cases, liabilities are classified as short-term, long-term, and other liabilities. When making comparisons between companies in the same industry, a high D/E ratio indicates a heavier reliance on debt. If the debt to equity ratio gets too high, the cost of borrowing will skyrocket, as will the cost of equity, and the company’s WACC will get extremely high, driving down its share price. In the example below, we see how using more debt (increasing the debt-equity ratio) increases the company’s return on equity (ROE).

Calculating a Company’s D/E Ratio

In general, a lower D/E ratio is preferred as it indicates less debt on a company’s balance sheet. However, this will also vary depending on the stage of the company’s growth and its industry sector. D/E ratios should always be considered on a relative basis compared to industry peers or to the same company at different points in time. Acceptable levels of the total debt service ratio range from the mid-30s to the low-40s in percentage terms. Some sources consider the debt ratio to be total liabilities divided by total assets. This reflects a certain ambiguity between the terms debt and liabilities that depends on the circumstance.

A low D/E ratio shows a lower amount of financing by debt from lenders compared to the funding by equity from shareholders. If a company cannot pay the interest and principal on its debts, whether as loans to a bank or in the form of bonds, it can lead to a credit event. The D/E ratio is one way to look for red flags that a company is in trouble in this respect. A company that does not make use of the leveraging potential of debt financing may be doing a disservice to the ownership and its shareholders by limiting the ability of the company to maximize profits. The optimal debt-to-equity ratio will tend to vary widely by industry, but the general consensus is that it should not be above a level of 2.0.

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Liabilities are items or money the company owes, such as mortgages, loans, etc. Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI’s full course catalog and accredited Certification Programs. A financial professional will offer guidance based on the information provided and offer a no-obligation call to better understand your situation. Our team of reviewers are established professionals with decades of experience in areas of personal finance and hold many advanced degrees and certifications. Finance Strategists has an advertising relationship with some of the companies included on this website.

The reason for this is there are still loans that need to be paid while also not having enough to meet its obligations. It shows the proportion to which a company is able to finance its operations via debt rather than its own resources. It is also a long-term risk assessment of the capital structure of a company and provides insight over time into its growth strategy.

1. The D/E ratio indicates how reliant a company is on debt to finance its operations.
2. It is the opposite of equity financing, which is another way to raise money and involves issuing stock in a public offering.
3. With this information, investors can leverage historical data to make more informed investment decisions on where they think the company’s financial health may go.
4. The periods and interest rates of various debts may differ, which can have a substantial effect on a company’s financial stability.
5. For information pertaining to the registration status of 11 Financial, please contact the state securities regulators for those states in which 11 Financial maintains a registration filing.

While using total debt in the numerator of the debt-to-equity ratio is common, a more revealing method would use net debt, or total debt minus cash in cash and cash equivalents the company holds. The debt-to-equity ratio also gives you an idea of how solvent a company is, says Joe Fiorica, head of Global Equity Strategy at Citi Global Wealth. “Solvency refers to a firm’s ability to meet financial obligations over the medium-to-long term.” Assessing whether a D/E ratio is too high or low means viewing it in context, such as comparing to competitors, looking at industry averages, and analyzing cash flow. Like the D/E ratio, all other gearing ratios must be examined in the context of the company’s industry and competitors. As an example, the furnishings company Ethan Allen (ETD) is a competitor to Restoration Hardware.

A high D/E ratio suggests that the company is sourcing more of its business operations by borrowing money, which may subject the company to potential risks if debt levels are too high. When looking at a company’s balance sheet, it is important to consider the average D/E ratios for the given industry, as well as those of the company’s closest competitors, and that of the broader market. The interest paid on debt also is typically tax-deductible for the company, while equity capital is not. Attributing preferred shares to one or the other is partially a subjective decision but will also take into account the specific features of the preferred shares. Perhaps 53.6% isn’t so bad after all when you consider that the industry average was about 75%.