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
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 a financial leverage ratio, which is frequently calculated and analyzed, that compares a company's total liabilities to its shareholder equity.
- The D/E ratio is considered to be a gearing ratio, a financial ratio that compares the owner's equity or capital to debt, or funds borrowed by the company.
- The debt-to-equity ratio is calculated by dividing a corporation's total liabilities by its shareholder equity.
- The optimal D/E ratio varies by industry, but it should not be above a level of 2.0.
- A D/E ratio of 2 indicates the company derives two-thirds of its capital financing from debt and one-third from shareholder equity.
What Is Considered A High Debt-To-Equity Ratio?
What Is a Good 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 debt-to-equity ratio is often associated with risk: A higher ratio suggests higher risk and that the company is financing its growth with debt. However, when a company is in its growth phase, a high D/E ratio might be necessary for that growth.
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 its 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.
The average D/E ratio among S&P 500 companies is approximately 1.6. Each industry will vary in its average based on how capital-intensive it is and how much debt is needed to operate. Thus. The financial sector, for example, often has a relatively D/E ratio, but this is not indicative of greater risk, just the nature of the business.
Industry average D/E ratios can be found here.
Is a Higher or Lower Debt-to-Equity Ratio Better?
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. Newer and growing companies often use debt to fuel growth, for instance. 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.
What Type of Ratio Is the Debt-to-Equity Ratio?
The D/E ratio can be classified as a leverage ratio (or gearing ratio) that shows the relative amount of debt a company has. As such, it is also a type of solvency ratio, which estimates how well a company can service its long-term debts and other obligations. This is in contrast to a liquidity ratio, which considers the ability to meet short-term obligations.
What Does a High Debt-to-Equity Ratio Mean?
For a mature company, a high D/E ratio can be a sign of trouble that the firm will not be able to service its debts and can eventually lead to a credit event such as default. For a growing company, a high D/E could be a healthy sign of expansion. In all cases, D/E ratios should be considered relative to a company's industry and growth stage.
Why Is Debt-to-Equity Ratio Important?
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. In the event of a default, the company may be forced into bankruptcy. The D/E ratio is one way to look for red flags that a company is in trouble in this respect.