What Is a High Debt-to-Equity Ratio?
The debt-to-equity (D/E) ratio is a metric that provides insight into a company's use of debt. In general, a company with a high D/E ratio is considered a higher risk to lenders and investors because it suggests that the company is financing a significant amount of its potential growth through borrowing. What is considered a high ratio can depend on a variety of factors, including the company's industry.
- The debt-to-equity (D/E) ratio reflects a company's debt status.
- A high D/E ratio is considered risky for lenders and investors because it suggests that the company is financing a significant amount of its potential growth through borrowing.
- Whether a D/E ratio is high or not depends on many factors, such as the company's industry.
What Is Considered A High Debt-To-Equity Ratio?
Understanding the Debt-to-Equity (D/E) Ratio
The D/E ratio relates the amount of a firm’s debt financing to its equity. To calculate the D/E ratio, divide a firm's total liabilities by its total shareholder equity—both items are found on a company's balance sheet. The company’s capital structure is the driver of the debt-to-equity ratio. The more debt a company uses, the higher the debt-to-equity ratio will be.
Debt typically has a lower cost of capital compared to equity, mainly because of its seniority in the case of liquidation. Thus, many companies may prefer to use debt over equity for capital financing. In some cases, the debt-to-equity calculation may be limited to include only short-term and long-term debt. Most often, it also includes some form of additional fixed payments. Together, the total debt and total equity of a company combine to equal its total capital, which is also accounted for as total assets.
Analyzing the Debt-to-Equity (D/E) Ratio by Industry
As is typical in financial analysis, a single ratio, or a line item, is not viewed in isolation. Therefore, the D/E ratio is typically considered along with a few other variables. One of the main starting points for analyzing a D/E ratio is to compare it to other company's D/E ratios in the same industry. Overall, D/E ratios will differ depending on the industry because some industries tend to use more debt financing than others. In the financial industry, for example, the D/E ratio tends to be higher than in other sectors because banks and other financial institutions borrow money to lend money, which can result in a higher level of debt.
Other industries that tend to have large capital project investments also tend to be characterized by higher D/E ratios. These industries can include utilities, transportation, and energy.
Special Considerations for the Analysis of D/E Ratios
A popular variable for consideration when analyzing a company’s D/E ratio is its own historical average. A company may be at or below the industry average but above its own historical average, which can be a cause for concern. In this case, it is important to analyze the company’s current situation and the reasons for the additional debt.
The weighted average cost of capital (WACC) can provide insight into the variability of a company’s D/E ratio. The WACC shows the amount of interest financing on the average per dollar of capital. The equation also breaks down the average payout for debt and equity.
If a company has a low average debt payout, this implies that the company is obtaining financing in the market at a relatively low rate of interest. This advantage can make the use of debt more attractive, even if the D/E ratio is higher than comparable companies.