Is there value in comparing companies from different sectors by using the debt-to-equity ratio?

By Jean Folger AAA
A:

The debt-to-equity ratio is a measure of a company's financial leverage that relates the amount of a firms' debt financing to the amount of equity financing. It is calculated by dividing a firm's total liabilities by total shareholders' equity.

Because some industries tend to use more debt financing than others, it generally is not helpful to compare the debt-to-equity ratio of companies from different sectors. A company in the industrial goods sector, for example, is likely to have a much higher debt-to-equity ratio than a company in the basic materials sector. Average debt-to-equity ratios also vary within the sector by industry. In the consumer goods sector, for example, the electronic equipment industry tends to have lower debt-to-equity ratios than the beverages/soft drinks industry.

Consider a company with a debt-to-equity ratio of 50.00. In the basic materials sector, which as of June 2014 had an average debt-to-equity ratio of 44.04, this would be a bit high. But in the industrial goods sector, which had a debt-to-equity ratio of 362.27 at the same time, a ratio of 50.00 would be low. Comparing only the debt-to-equity ratios of companies from different sectors will not provide investors with an accurate picture, and other measures should be used before making any investment decisions.

RELATED FAQS

  1. What is considered a good PEG (price to earnings growth) ratio?

    Learn about the price/earnings to growth (PEG) ratio and understand what investors and market analysts consider a good ratio ...
  2. What is the formula for calculating the quick ratio in Excel?

    Understand the basics of the quick ratio, including how it is used as a measure of a company's liquidity and how to calculate ...
  3. What is the difference between profitability and profit?

    Calculating company profit and profitability are not one and the same, and investors should understand the difference between ...
  4. Should companies break out accounts receivables into subledgers?

    Find out why every company that sells on credit should break down its accounts receivable into individual customer subsidiary ...
RELATED TERMS
  1. Debt/Equity Ratio

    A measure of a company's financial leverage calculated by dividing ...
  2. Best's Capital Adequacy Relativity (BCAR)

    A rating of an insurance company’s balance sheet strength. Best’s ...
  3. Deferred Tax Asset

    A deferred tax asset is an asset on a company's balance sheet ...
  4. Earnings Per Share - EPS

    The portion of a company's profit allocated to each outstanding ...
  5. Return On Investment - ROI

    A performance measure used to evaluate the efficiency of an investment ...
  6. Working Capital

    This ratio indicates whether a company has enough short term ...

You May Also Like

Related Articles
  1. Active Trading

    5 Must-Have Metrics For Value Investors

  2. Investing

    What Happened To Obama’s Amnesty Bill?

  3. Charts & Patterns

    The Future of Qualcomm's Stock

  4. Fundamental Analysis

    Earnings Quality, the Facebook Example

  5. Trading Strategies

    Novice Trading Strategies

Trading Center