Some of the major reasons why the debt/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 relatively easier to manage.
The industries that typically have the highest D/E ratios include utilities and financial services. Wholesalers and service industries are commonly among those with the lowest.
The Debt/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 is utilizing.
The formula used to calculate the ratio divides a company’s total liabilities by the total amount of shareholder equity in the company.
Why Debt/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 prior to delivering its first good or service and generating any revenue.
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/Equity Ratios
The financial sector overall has one of the highest D/E ratios, but 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 operation increasingly through creditors rather than through employing its own resources, and that it has a relatively higher fixed interest rate charges 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 liquidation. Extraordinarily high ratios are unattractive to lenders and may make it more difficult to obtain additional financing.
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.