What is the Debt/Equity Ratio
The Debt/Equity (D/E) Ratio is calculated by dividing a company’s total liabilities by its shareholder equity. These numbers are available on the balance sheet of a company’s financial statements. The ratio is used to evaluate a company's financial leverage. The debt/equity ratio is also referred to as a risk or gearing ratio. The formula for calculating the D/E ratio is:
The balance sheet requires total shareholder equity to equal assets minus liabilities, which is a rearranged version of the balance sheet equation (Assets = Liabilities + Shareholder Equity). These balance sheet categories may contain individual accounts that would not normally be considered “debt” or “equity” in the traditional sense of a loan or the book value of an asset. Because the ratio can be distorted by retained earnings/losses, intangible assets, and pension plan adjustments, further research is usually needed to understand a company’s true leverage.
Because of the ambiguity of some of the accounts in the primary balance sheet categories, analysts and investors will often modify the D/E ratio to be more useful and easier to compare between different stocks. Analysis of the D/E ratio can also be improved by including short-term leverage ratios, profit performance, and growth expectations.
The Debt To Equity Ratio
BREAKING DOWN Debt/Equity Ratio
Debt/Equity Ratio for Corporate Fundamental Analysis
Given that the debt/equity ratio measures a company’s debt relative to the value of its net assets, it is most often used to gauge the extent to which a company is taking on debt as a means of leveraging its assets. A high debt/equity ratio is often associated with high risk; it means that a company has been aggressive in financing its growth with debt.
At the end of 2017, Apache Corp (APA) had total liabilities of $13.1 billion, total shareholder equity of $8.79 billion, and a debt/equity ratio of 1.49. Conoco Phillips (COP) had total liabilities of $42.56 billion, total shareholder equity of $30.8 billion, and a debt/equity ratio of 1.38 at the end of 2017.
APA: $13.1 / $8.79 = 1.49
COP: $42.56 / $30.8 = 1.38
On the surface, it appears that APA’s higher leverage ratio indicates higher risk. However, this may be too generalized to be helpful at this stage and further investigation would be needed.
If a lot of debt is used to finance growth, a company could potentially generate more earnings than it would have without that financing. If leverage increases earnings by a greater amount than the debt’s cost (interest), then shareholders should expect to benefit. However, if the cost of debt financing outweighs the increased income generated, share values may decline. The cost of debt can vary with market conditions, thus unprofitable borrowing may not be apparent at first.
Changes in long-term debt and assets tend to have the greatest impact on the D/E ratio because they tend to be larger accounts compared to short-term debt and short-term assets. If investors want to evaluate a company’s short-term leverage and its ability to meet debt obligations that must be paid over a year or less, other ratios will be used. For example, an investor who needs to compare a company’s short-term liquidity or solvency will use the cash ratio (cash & marketable securities ÷ short-term liabilities = cash ratio) or the current ratio (short-term assets ÷ short-term liabilities = current ratio) instead of a long-term measure of leverage like the D/E ratio.
Limitations of Debt/Equity Ratio
When using the debt/equity ratio it is very important to consider the industry within which the company exists. Because different industries have different capital needs and growth rates, a relatively high D/E ratio may be common in one industry, meanwhile a relatively low D/E may be common in another. For example, capital-intensive industries such as auto manufacturing tend to have a debt/equity ratio above 2, while tech or services firms could have a typical debt/equity ratio under 0.5.
Utilities stocks often have a very high D/E ratio compared to market averages. A utility grows slowly but is usually able to maintain a steady income stream which allows these companies to borrow very cheaply. High leverage ratios in slow growth industries with stable income represent an efficient use of capital. The consumer staples or consumer non-cyclical sector tends to also have a high debt to equity ratio because these companies can borrow cheaply and have relatively stable income.
Analysts are not always consistent about what is defined as debt. For example, preferred stock is sometimes considered equity, but the preferred dividend, par value, and liquidation rights makes this kind of equity look a lot more like debt. Including preferred stock in total debt will increase the D/E ratio and make a company look more risky. Including preferred stock in the equity portion of the D/E ratio will increase the denominator and lower the ratio. It can be a big issue for companies like real estate investment trusts when preferred stock is included in the D/E ratio.
You can see how reclassifying preferred equity can change the D/E ratio in the following example where it is assumed a company has $500,000 in preferred stock, $1 million in total debt (excluding preferred stock), and $1.2 million in total shareholder equity (excluding preferred stock).
Debt to Equity ratio with preferred stock as part of total liabilities:
Debt to Equity ratio with preferred stock as part of shareholder equity:
Other financial accounts, such as unearned income, will be classified as debt and can distort the D/E ratio. Imagine a company with a prepaid contract to construct a building for $1 million. The work is not complete, so the $1 million is considered a liability. Assume that the company has purchased $500,000 of inventory and materials to complete the job which has increased total assets and shareholder equity. If these amounts are included in the D/E calculation, the numerator will be increased by $1 million and the denominator by $500,000 which will increase the ratio.
Modifications to Debt/Equity Ratio
The shareholder’s equity portion of the balance sheet is equal to the total value of assets minus liabilities, but that isn’t the same thing as assets minus the debt associated with those assets. A common approach to resolving this issue is to modify the debt/equity ratio into the long-term debt/equity ratio. An approach like this helps an analyst focus on important risks.
Short-term debt is still part of the overall leverage of a company, but because these liabilities will be paid in a year or less, they aren’t as risky. For example, imagine a company with $1 million in short term payables (wages, accounts payable, notes etc.) and $500,000 of long-term debt compared to a company with $500,000 in short-term payables and $1 million in long term debt. If both companies have $1.5 million in shareholder equity then they both have a D/E ratio of 1.00. On the surface, the risk from leverage is identical, but in reality the first company is riskier.
As a rule, short-term debt tends to be cheaper than long-term debt and it is less sensitive to shifting interest rates; the first company’s interest expense and cost of capital is higher. If interest rates fall, long-term debt will need to be refinanced which can further increase costs. Rising interest rates would seem to favor the company with more long-term debt, but if the debt can be redeemed by bond holders it could still be a disadvantage.
Debt/Equity Ratio for Personal Finances
The Debt/Equity (D/E) ratio can be applied to personal financial statements as well, in which case it is also known as the Personal Debt/Equity Ratio. Here, “equity” refers to the difference between the total value of an individual’s assets and the total value of his/her debt or liabilities. The formula for the personal D/E ratio is represented as:
The personal debt/equity ratio is often used when an individual or small business is applying for a loan. Lenders use the D/E to evaluate how likely it would be that the borrower is able to continue making loan payments if their income was temporarily disrupted. For example, a prospective mortgage borrower is likely to be able to continue making payments if they have more assets than debt, if they were to be out of a job for a few months. This is also true for an individual applying for a small business loan or line of credit. If the business owner has a good personal debt/equity ratio, it is more likely that they can continue making loan payments while their business is growing.
Debt/Equity Ratio Summary
The debt/equity (D/E) ratio compares a company’s total liabilities to its shareholder equity. Investors can use the D/E ratio to evaluate how much leverage a company is using. Higher leverage ratios tend to indicate a company or stock with higher risk to shareholders. However, the D/E ratio is difficult to compare across industry groups where ideal amounts of debt will vary. Investors will often modify the D/E ratio to focus on long-term debt only because the risk of long-term liabilities are different than for short-term debt and payables.