The debt-to-equity ratio is a metric that provides insight on a company's use of debt. It relates the amount of a firm’s debt financing to its equity. The ratio divides a firm's total liabilities by the firm’s total shareholders' equity. In some cases, the debt-to-equity calculation may be more isolated to include only short-term and long-term debt but 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.
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. 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 and vice versa.
As is typical in financial analysis, a single ratio or line item is usually not used in isolation. As such, 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 debt-to-equity ratio is the company’s industry. Therefore, the average debt-to-equity ratio for a company’s industry is often a good baseline for considering how high the debt-to-equity ratio should be. Below is a chart with debt-to-equity ratios by industry. As of 2019, the services industry had the lowest average debt-to-equity ratio at 0.05% while the financial industry had the highest at 1.89%.
Overall, debt-to-equity ratios will differ depending on the industry, because some industries tend to utilize more debt financing than others. Closely comparable companies within an industry group can also be important to examine for deeper analysis. In the financial industry, for example, the debt-to-equity ratio is higher 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.
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 flag for concern. In this case, it can be important to analyze the company’s current situation and the reasons for the additional debt it is adding.
Lastly, the weighted average cost of capital (WACC) can 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 WACC 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 which can make the use of debt more attractive even if the debt-to-equity ratio is higher than comparable companies.