Financial analysts and investors are often very interested in analyzing financial statements in order to carry out financial ratio analysis to understand a company's economic health and to determine if an investment is considered worthwhile or not.
The debt-to-equity ratio (D/E) is a financial leverage ratio that is frequently calculated and looked at. It is considered to be a gearing ratio. Gearing ratios are financial ratios that compare the owner's equity or capital to debt, or funds borrowed by the company.
The debt-to-equity ratio is determined by dividing a corporation's total liabilities by its shareholder equity.
This ratio compares a company's total liabilities to its shareholder equity. It is widely considered one of the most important corporate valuation metrics because it highlights a company's dependence on borrowed funds and its ability to meet those financial obligations.
Because debt is inherently risky, lenders and investors tend to favor businesses with lower D/E ratios. For lenders, a low ratio means a lower risk of loan default. For shareholders, it means a decreased probability of bankruptcy in the event of an economic downturn. A company with a higher ratio than its industry average, therefore, may have difficulty securing additional funding from either source.
The debt-to-equity ratio is associated with risk: a higher ratio suggests higher risk and that the company is financing its growth with debt.
The Preferred Debt-to-Equity Ratio
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. While some very large companies in fixed asset-heavy industries (such as mining or manufacturing) may have ratios higher than 2, these are the exception rather than the rule.
A D/E ratio of 2 indicates that the company derives two-thirds of its capital financing from debt and one-third from shareholder equity, so it borrows twice as much funding as it owns (2 debt units for every 1 equity unit). A company's management will, therefore, try to aim for a debt load that is compatible with a favorable D/E ratio in order to function without worrying about defaulting on its bonds or loans.
The ideal D/E ratio, meaning two-thirds of the firm's money comes from debt and one-third from equity, or that the firm borrows twice what it owns.
Why Debt Capital Matters
A business that ignores debt financing entirely may be neglecting important growth opportunities. The benefit of debt capital is that it allows businesses to leverage a small amount of money into a much larger sum and repay it over time. This allows businesses to fund expansion projects more quickly than might otherwise be possible, theoretically increasing profits at an increased rate.
A company that does not make use of the leveraging potential of debt financing may be doing a disservice to the ownership and shareholders by limiting the ability of the company to generate maximum profits.
The interest paid on debt is also typically tax-deductible for the company, while equity capital is not. Debt capital also usually carries a lower cost of capital than equity.
Role of Debt-to-Equity Ratio in Company Profitability
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.
If a company has a D/E ratio of 5, but the industry average is 7, this may not be an indicator of poor corporate management or economic risk. There are also many other metrics used in corporate accounting and financial analysis that are used as indicators of financial health that should be studied alongside the D/E ratio.