The debt-to-equity ratio shows the proportion of equity and debt a company is using to finance its assets and the extent to which shareholder's equity can fulfill obligations to creditors in the event of a business decline.
A low debt-to-equity ratio indicates a lower amount of financing by debt via lenders versus funding through equity via shareholders. A higher ratio indicates the company is getting more of their financing from borrowing which may pose a risk to the company if debt levels are too high.
A greater degree to which operations are funded by borrowed money means a greater risk of bankruptcy if business declines. Minimum payments on loans and other debts must still be met even if, due to an economic downturn or competition, a company does not earn enough profit to meet its obligations. For a highly leveraged company, sustained earnings declines could lead to financial distress or bankruptcy.
The Debt To Equity Ratio
How to Calculate Debt-to-Equity:
Example of Debt-to-Equity
Apple Inc. (AAPL)
We can see below that for the fiscal year ending of 2017, Apple had total liabilities of $241 billion (rounded) and total shareholders' equity of $134 billion, according to their 10K statement.
Using the above formula, the debt-to-equity ratio for AAPL can be calculated as:
Debt-to-equity = $241 ÷ $134 = 1.80
The result means that Apple had $1.80 of debt for every dollar of equity. On its own, the ratio doesn't give investors the complete picture. It's important to compare the ratio to other similar companies.
For example, for the end of 2017, General Motors had a debt-to-equity ratio of 5.03, which was far higher than Apple's. However, the two companies are in different industries. Given the capital expenditures needed to operate manufacturing plants around the world, it makes sense that GM has a higher ratio since they'd likely have more liabilities. When we compare the ratios to company's within their industries, we get a clearer picture of how the companies are performing.
Debt-to-equity for the fiscal year ending 2017:
We can see above that GM's debt-to-equity ratio of 5.03 compared to Ford's 6.37 is not as high as it was when compared to Apple's 1.80 debt-to-equity ratio. However, when comparing Apple to technology companies like Netflix and Amazon, it certainly appears that Apple uses far less debt financing than the other two companies. Of course, that's not to say that the debt-to-equity ratios for Amazon and Netflix are too high, but it might prompt investors to look into the companies' balance sheets for trends over the past few years to determine how they are using their debt to drive earnings.
The debt-to-equity ratio can help investors identify companies that are highly leveraged and that may pose a higher risk of financial. Investors can compare a company's debt-to-equity ratio against industry averages and other similar companies to gain a general indication of a company's equity-liability relationship.
Of course, it's not as simple as saying a high debt-to-equity ratio is a sign of poor business practices. In fact, debt can be the catalyst that allows a company to expand operations and generate additional income for both the business and its shareholders. Some industries, such as the auto and construction industries, typically have higher ratios than others because getting started and maintaining inventory are capital-intensive. Companies with intangible products such as online services may have lower standard D/E ratios. Evaluate a company's historical ratio, as well as those of similar companies in the same industry, when evaluating financial health.