The debt-to-equity ratio shows the proportions of equity and debt a company is using to finance its assets and it signals the extent to which shareholder's equity can fulfill obligations to creditors, in the event a business declines.
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 that the company is getting more of its financing by borrowing money, which subjects the company to potential risk if debt levels are too high. Simply put: the more a company's operations rely on borrowed money, the greater the risk of bankruptcy, if the business hits hard times. This is because minimum payments on loans must still be paid--even if a company has not profited enough to meet its obligations. For a highly leveraged company, sustained earnings declines could lead to financial distress or bankruptcy.
- The debt-to-equity ratio shows the proportion of equity and debt a company is using to finance its assets and signals the extent to which shareholder's equity can fulfill obligations to creditors, in the event of a business decline.
- The more a company's operations are funded by borrowed money, the greater the risk of bankruptcy, if the business hits hard times.
- Debt can also be helpful, in facilitating a company's healthy expansion.
The Debt To Equity Ratio
How to Calculate Debt-to-Equity:
To calculate debt-to-equity, divide a company's total liabilities by its total amount of shareholders' equity as shown below.
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 = $241,000,000 ÷ $134,000,000 = 1.80
The result means that Apple had $1.80 of debt for every dollar of equity. But 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--far higher than Apple's. However, the two companies are players in different industries. And given the capital expenditures needed to operate manufacturing plants around the world, it makes sense that GM has a higher ratio since it's likely to have more liabilities. Comparing the ratios to company's within their industries presents 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 becomes apparent that Apple uses far less debt financing than those two companies. Of course, that's not to say that the debt-to-equity ratios for Amazon and Netflix are too high, however, that number may inspire investors to take a peek at the companies' balance sheets, to determine how they are using their debt to drive earnings.
The debt-to-equity ratio can help investors identify highly leveraged companies that may pose risks, during rough patches. 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. But not all high debt-to-equity ratios signal poor business practices. In fact, debt can catalyze the expansion of a company's operations and ultimately generate additional income for both the business and its shareholders.