Some of the major reasons why the debt-to-equity (D/E) ratio varies significantly from one industry to another, and even between companies within an industry, include different capital intensity levels between industries and whether the nature of the business makes carrying a high level of debt easier to manage.
The industries that typically have the highest D/E ratios include utilities and financial services. Wholesalers and service industries are among those with the lowest.
- The debt-to-equity (D/E) ratio measures how much of a business's operations are financed through debt versus equity.
- A higher D/E ratio indicates that a company is financed more by debt than it is by its wholly-owned funds.
- Depending on the industry, a high D/E ratio can indicate a company that is riskier.
- D/E ratios vary across industries because some industries are more capital intensive than others.
- The financial sector has one of the highest D/E ratios but this is not indicative of high risk, just the nature of the business.
The Debt-To-Equity Ratio
The D/E ratio is a basic metric used to assess a company's financial situation. It indicates the relative proportion of equity and debt that a company uses to finance its assets and operations. The ratio reveals the amount of financial leverage a company uses. The formula is total liabilities divided by total shareholders' equity.
Why Debt-To-Equity Ratios Vary
One of the major reasons why D/E ratios vary is the capital-intensive nature of the industry. Capital-intensive industries, such as oil and gas refining or telecommunications, require significant financial resources and large amounts of money to produce goods or services.
For example, the telecommunications industry has to make very substantial investments in infrastructure, installing thousands of miles of cables to provide customers with service. Beyond that initial capital expenditure, necessary maintenance, upgrades, and expansion of service areas require additional major capital expenditures. Industries such as telecommunications or utilities require a company to make a large financial commitment before delivering its first good or service and generating any revenue.
If a company is in decline then a high D/E ratio is of concern, conversely, if a company is on the rise, a high D/E ratio might be necessary for growth.
Another reason why D/E ratios vary is based upon whether the nature of the business means that it can manage a high level of debt. For example, utility companies bring in a stable amount of income; demand for their services remains relatively constant regardless of overall economic conditions. Also, most public utilities operate as virtual monopolies in the regions where they do business; so, they do not have to worry about being cut out of the marketplace by a competitor.
Such companies can carry larger amounts of debt with less genuine risk exposure than a business with revenues that are more subject to fluctuation in accord with the overall health of the economy.
The Highest Debt-To-Equity Ratios
The financial sector overall has one of the highest D/E ratios; however, looked at as a measure of financial risk exposure, this can be misleading. Borrowed money is a bank's stock in trade. Banks borrow large amounts of money to loan out large amounts of money, and they typically operate with a high degree of financial leverage. D/E ratios higher than 2 are common for financial institutions.
Other industries that commonly show a relatively higher ratio are capital-intensive industries, such as the airline industry or large manufacturing companies, which utilize a high level of debt financing as a common practice.
Importance of Relative Debt and Equity
The D/E ratio is a key metric used to examine a company's overall financial soundness. An increasing ratio over time indicates that a company is financing its operations increasingly through creditors rather than through employing its resources and that it has a relatively higher fixed interest rate charge burden on its assets.
Investors typically prefer companies with low D/E ratios as it means their interests are better protected in the event of a liquidation. Extraordinarily high ratios are unattractive to lenders and may make it more difficult to obtain additional financing.
A low D/E ratio is sometimes not desirable as it can indicate that a company is not using its assets efficiently.
The average D/E ratio among S&P 500 companies is approximately 1.5. A ratio lower than 1 is considered favorable since that indicates a company is relying more on equity than on debt to finance its operating costs. Ratios higher than 2 are generally unfavorable, although industry and similar company averages have to be considered in the evaluation. The D/E ratio can also indicate how generally successful a company is at attracting equity investors.
The Bottom Line
The D/E ratio measures the proportion of how a company finances its operations with debt versus equity. Each industry has a different parameter of what constitutes a good or bad D/E ratio based on their capital requirements and revenue-generating capabilities.
Generally, the lower the D/E ratio the better, as it indicates a company does not have significant debt burdens and generates enough income through its core operations to run its business.