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 viewed as a higher risk to lenders and investors because it suggests that the company has financed a larger amount of its growth through borrowing. What is considered a high ratio can depend on a variety of factors, including the company's industry.
Calculating the D/E Ratio
The D/E ratio relates the amount of a firm’s debt financing to its equity. To calculate it, divide a firm's total liabilities by its total shareholder equity—both items that can be 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 more isolated 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 D/E Ratios by Industry
As is typical in financial analysis, a single ratio or line item is usually not used in isolation. For that reason, the level of the debt-to-equity ratio is usually considered along with a few other variables.
However, one of the main starting points for analyzing a D/E ratio is the company’s industry. Looking at the average D/E ratio for a company’s industry is often a good baseline for considering how high its D/E ratio should be.
Overall, debt-to-equity ratios will differ depending on the industry because some industries tend to use more debt financing than others. It can also be important to examine closely comparable companies within an industry group for deeper analysis. In the financial industry, for example, the debt-to-equity ratio is higher than other industries 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 the need for large capital project investments will also usually have a higher debt-to-equity expectation. These industries can include utilities, transportation, and energy.
Other Factors in Analyzing D/E Ratios
A second variable for consideration when analyzing a company’s debt-to-equity ratio is its own historical average. A company may be at or below the average for the industry but above its own historical average, which can be a cause for concern. In that case, it can be important to analyze the company’s current situation and the reasons for the additional debt it's adding.
The weighted average cost of capital (WACC) can also provide interesting insight into the variability of a company’s debt-to-equity ratio. The WACC shows the amount of interest financing on 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 it means that it is able to get financing in the market at a relatively low rate. That can make the use of debt more attractive even if the debt-to-equity ratio is higher than comparable companies.