The Debt-to-Equity Ratio, or D/E, measures the amount of a company’s total debt in relation to the shareholders’ equity. As an important metric in corporate and personal finance, the D/E ratio is used to determine whether a company’s capital structure is more tilted toward debt or equity financing. In this article, we are going to take a closer look at how to calculate the Debt-to-Equity Ratio and its interpretation.
Highlights/ Key Takeaways
- Companies can raise the financial capital needed for their operations either through debt (borrowing from banks) or equity (selling stock to shareholders).
- The Debt-to-Equity Ratio is a leverage metric used to determine a company’s risk of being unable to repay what it owes.
- Both lenders and investors view companies with excessively high D/E values as high-risk and are, therefore, reluctant to place their money with such firms.
- The D/E ratio can also apply to personal financing, helping individuals determine their level of indebtedness and overall financial risk.
What Is Debt-to-Equity Ratio?
The Debt-to-Equity Ratio is a measure of a company’s financial leverage, which represents the relationship between the total amount of debt and equity used to finance a company's operations.
- Debt is the total amount of money that is borrowed for a specified term and must be returned in the future, along with the interest. For example, if a company takes out a small business loan or uses a line of credit to finance a project, it is taking on debt.
- Equity, or shareholder’s equity, is the net value of a company that is left after subtracting total liabilities from the company’s assets. Equity can also be calculated by adding together share capital (money received by the company from transactions with shareholders) and retained earnings (money earned through income).
The D/E ratio is considered a leverage ratio, which offers helpful insight into the capital structure of a company. A high Debt-to-Equity Ratio represents more debt financing, which often means higher risk.
The Debt-to-Equity Ratio can also be used when assessing one’s personal finances. For individual use, D/E helps to understand how much debt a person has relative to his or her assets, - an important metric to consider when making major financial decisions.
The Importance of a Debt-to-Equity Ratio to a Company
In a nutshell, the Debt-to-Equity Ratio measures the company’s reliance on debt and helps to determine whether it is tilted toward debt or equity financing.
A company with a lower ratio typically has less risk and more ability to raise additional growth capital. As such, many investors prefer companies with a D/E of 2 or below, meaning that the company’s debts are no more than double their equity. Moreover, some risk-averse investors feel comfortable investing when a company’s D/E does not exceed 1 to 1.5.
The Debt-to-Equity Ratio is also often used by bankers when deciding whether to offer a loan to a company. The bank or lender will consider the D/E value to evaluate the company’s ability to develop the necessary cash flow and profits to cover the loan payments and other expenses. In general, companies with lower D/E ratios are perceived as less risky borrowers.
“The Debt-to-Equity Ratio measures the company’s reliance on debt and helps to determine whether it is tilted toward debt or equity financing.”
The Debt-to-Equity Ratio Formula and Calculation
The Debt-to-Equity Ratio calculation is simple, - it equals debt divided by equity:
D/E = Total Debt / Total Shareholders’ Equity
Here, total debt includes short-term debt (due within one year), long-term debt (due after one year), and fixed payment obligations (fixed debt payments, insurance, taxes, utilities, etc.). Shareholder’s Equity is the difference between a company’s assets and liabilities.
Total Debt = Short-Term Debt + Long-Term Debt + Fixed Payment Obligations
Total Shareholders’ Equity = Assets - Liabilities
Some examples of a company's liabilities that are considered debt include drawn lines of credit, bonds payable, notes payable, long-term debt, and capital lease obligations. This and other information necessary to calculate the D/E ratio can be found on a company’s balance sheet.
Example
Suppose Company ABC has assets of $3 million and Shareholders’ Equity of $1.2 million.The D/E ratio can be calculated as follows:
D/E = $1.8 million / $1.2 million = 1.5
The Debt-to-Equity Ratio and Corporate Finance
When a company takes on debt to purchase assets, it is said to practice “financial leverage.” Of course, taking on debt will lead to additional interest expenses, but assets acquired through this type of business financing can lead to higher earnings that will cover the interest costs.
A highly-leveraged company will have most of its capital structure made up of debt. This means that it will have higher leverage ratios, such as Debt-to-Equity and Debt-to-Assets.
Companies often calculate and track their D/E ratios internally to understand the level of their leverage and their overall financial health. At the same time, investors and lenders try to avoid highly-leveraged companies, as a high D/E means that the company may have a harder time covering its liabilities.
The Debt-to-Equity Ratio and Personal Finance
The Debt-to-Equity Ratio is also widely used in personal finance. As such, individuals can calculate their D/E ratio to gain a better understanding of their financial situation using this formula:
Individual D/E = Total Debt / Net Worth, where
Net Worth = Personal Assets - Personal Liabilities
As with corporate finance, a higher individual D/E means that you have taken on more debt. It also means that you are a higher-risk borrower, as you may have trouble meeting financial obligations if you lose your source of income. The individual Debt-to-Equity Ratio can affect your credit score and the way lenders evaluate your application when you try to take out a mortgage, a loan, or a new credit card.
“The individual Debt-to-Equity Ratio can affect your credit score and the way lenders evaluate your application when you try to take out a mortgage, a loan, or a new credit card.”
Example
William’s liabilities include a student loan of $55,000, a mortgage of $657,000, a car loan of $25,000, and a credit card balance of $3,200. His assets include a house valued at $840,000, a car valued at $32,000, and $14,000 in savings.
William’s individual Debt-to-Equity Ratio can be calculated as:
Personal Assets = $840,000 + $32,000 + $14,000 = $886,000
Personal Liabilities = $55,000 + $657,000 + $25,000 + $3,200 = $740,200
Net Worth = $886,000 - $740,200 = $145,800
Individual D/E = $740,200 / $145,800 = 5.08
This means that William’s liabilities are approximately 5 times greater than his net worth.
Interpreting a Debt-to-Equity Ratio
With the Debt-to-Equity Ratio, it is important to stay within a reasonable range. If the company’s D/E is too high, it may signal too much debt and potential financial distress. On the other hand, if D/E is too low, it’s a sign that the company is over-relying on equity to finance the business, which can be costly and inefficient.
What Is a Good Debt-to-Equity Ratio?
A good rule of thumb is that most companies should aim to get a D/E of 2 or below. However, the acceptable D/E range will vary from industry to industry.
Depending on the industry the company is in, good D/E ranges include:
- Technology-based businesses: D/E of 2 or below
- Large manufacturing companies: D/E between 2 and 5
- Stable publicly traded companies: D/E between 2 and 5
- Banking and financial-based businesses: D/E up to 10 or higher
It is normal for banks and other financial institutions to rely heavily on debt for everyday operations, and it is not uncommon to see a D/E value of 10 or even 20 with such institutions. However, this is unique to the financial industry. You might want to consult industry benchmarks to obtain the average Debt-to-Equity Ratio by industry.
When it comes to the individual Debt-to-Equity, the lower the better. A D/E ratio of 0 means that an individual is debt-free, which is not a bad thing. Nonetheless, you might still want to carry a small amount of “good debt” to improve your credit rating.
Example
In the previous example, we have found that Company ABC has a Debt-to-Equity Ratio of 1.5. This ratio falls under the threshold of 2, which means that it would be considered “good” for most types of companies.
What Is a Bad Debt-to-Equity Ratio?
Depending on the industry the company is in, the definition of a “bad” D/E value will vary. While banks can get away with a D/E of 10 or above, most other companies should still aim to keep their D/Es at 2 or below. A higher D/E indicates higher risk, which means that investors and lenders will be less likely to place money with the company.
Similarly, when an individual's debts exceed his or her assets, that individual is at more financial risk. While you should avoid “bad debt” like high-interest loans and credit card debt, keeping small amounts of “good debt” like mortgage and auto loans is generally fine.
Debt-to-Equity Ratio Example
Calculating the Debt-to-Equity Ratio is fairly simple, with all the necessary information readily available on a company’s balance sheet. Let us take a look at a more detailed example of debt-to-equity ratio calculation and interpretation.
Suppose Company DEF has $230,000 in assets. Its Short-Term Debt amounts to $26,000, Long-Term Debt amounts to $58,000, and Fixed Payment Obligations amount to $13,000. Then:
Total Debt = Short-Term Debt + Long-Term Debt + Fixed Payment Obligations = $26,000 + $58,000 + $13,000 = $107,000
Total Shareholders’ Equity = Assets - Liabilities = $230,000 - $107,000 = $123,000
D/E = Total Debt / Total Shareholders’ Equity = $107,000 / $123,000 = 0.87
A D/E of 0.87 is generally considered very good. This means that for every $1 of the company owned by shareholders, the business owes $0.87 to creditors.
How Can Companies and Individuals Improve Their Debt-to-Equity Ratios?
If your company’s Debt-to-Equity Ratio is high, one of the most effective ways to improve it is to increase the company’s earnings. Then, as your company’s equity increases, you will be able to use the funds to pay off debts and purchase new assets. Alternatively, you could try to restructure the company’s debt to help get its finances back on track.
Similarly, an individual can improve his or her Debt-to-Equity Ratio by increasing income and using it to pay down debt. When possible, it is also recommended to avoid taking on additional debt, as doing so would increase the individual total debt, and, therefore the D/E value.
What Industries Have the Highest Debt-to-Equity Ratios?
Overall, the financial sector has some of the highest D/E ratios, which do not signal higher financial risk exposure in that case. It is normal for banks and other financial institutions to have a high degree of leverage, borrowing large amounts of money to later lend them out.
Other industries with a relatively high D/E ratio include capital-intensive industries like large manufacturing companies or the airline industry. With these sectors, utilizing a high level of debt financing is common.
Other Important Debt Ratios
Along with the Debt-to-Equity Ratio, other metrics can be used to evaluate a company’s financial health and debt capacity. Other important debt ratios to consider include the Debt-to-Assets Ratio, the Debt-to-Capital Ratio, and the Debt-to-EBITDA Ratio.
Debt-to-Assets Ratio
The Debt-to-Assets Ratio (D/A) can be calculated as:
D/A = Total Debt / Total Assets
Unlike the Debt-to-Equity Ratio, which indicates a company’s financial leverage, the Debt-to-Assets Ratio is a measure of a company's total liabilities. In simple words, the D/A ratio shows what percentage of a company’s assets is financed by creditors.
Debt-to-Capital Ratio
The Debt-to-Capital Ratio (D/C) is another metric used to evaluate the level of a firm’s financial leverage. It can be calculated as:
D/C = Debt / (Debt + Shareholders’ Equity)
The D/C ratio is calculated by dividing a company’s total debt by its total capital, or a sum of its debt and equity. In contrast, the Debt-to-Equity Ratio divides debt by shareholders’ equity alone.
Debt-to-EBITDA Ratio
The Debt-to-EBITDA Ratio is often used to measure a company’s ability to repay its incurred debt. The ratio can be calculated as:
Debt-to-EBITDA = Debt / EBITDA
Here, the debt includes long- and short-term obligations, while “EBITDA” stands for Earnings before Interest, Taxes, Depreciation, and Amortization. EBITDA is a measure of the earnings from the company’s operations, which means that the Debt-to-EBITDA ratio represents how well the company can cover its debts with earnings.
Final Word
To recap, the Debt-to-Equity Ratio is an important measure of financial risk used in both corporate and personal finance. In the corporate context, the D/E ratio evaluates the level of a company's financial leverage or how much debt it has taken on to finance its operations. Similarly, the individual D/E ratio can be used to measure the amount of individual debt and the associated financial risk.
