Debt-to-Equity (D/E) Ratio: Formula and Interpretation
The debt-to-equity or D/E ratio compares a company’s total liabilities (what it owes) to its shareholder equity. The result gives investors a snapshot of how much a company relies on borrowed money, a.k.a. leverage, versus its own capital.
The D/E ratio is one of the most widely used financial metrics for evaluating how a company finances its operations — and how risky that financing structure might be.
A high D/E ratio could indicate that a company is overleveraged, making it riskier for investors. Also, consider that the cost of capital is higher now, given today’s higher interest-rate environment.
On the other hand, a low D/E ratio could indicate underutilization of debt for growth opportunities and tax benefits.
Debt-to-equity ratios can vary by industry. It’s important for investors to use the D/E ratio to make direct comparisons, or to measure a company’s use of debt over time.
Table of Contents
- What Is the Debt-to-Equity (D/E) Ratio?
- The Debt-to-Equity (D/E) Ratio Formula
- How to Calculate D/E: Step by Step
- Real World Example of a D/E Calculation
- Interpreting the D/E Ratio
- What the D/E Ratio Tells Investors
- What Does It Mean for a D/E Ratio to Be Negative?
- Average D/E Ratios by Industry
- Effect of Debt-to-Equity Ratio on Stock Price
- Debt-to-Equity (D/E) Ratio vs Gearing Ratio
- Why Companies Monitor Their D/E Ratios
- Analyzing IPOs Using the D/E Ratio
- The Limitations of Debt-to-Equity Ratios
- FAQ
Key Points
• The debt-to-equity ratio (D/E) is a financial metric that compares a company’s total liabilities to its shareholder equity, indicating its reliance on debt for financing.
• Calculating the D/E ratio involves dividing total liabilities by shareholder equity, with the resulting figure helping investors assess potential risks associated with a company’s financial structure.
• A high D/E ratio may suggest a company is overleveraged, making it riskier for investors, while a low ratio could indicate underutilization of debt for growth opportunities.
• Different industries have varying acceptable D/E ratios, with capital-intensive sectors often operating with higher ratios due to their borrowing needs for growth.
• The D/E ratio is just one of many indicators investors should consider, as it should be contextualized within industry standards and accompanied by a broader analysis of a company’s financial health.
What Is the Debt-to-Equity (D/E) Ratio?
The debt-to-equity ratio is one of several metrics that investors can use to evaluate individual stocks. At its simplest, the debt-to-equity ratio is a quick way to assess a company’s total liabilities vs. total shareholder equity, to gauge the company’s reliance on debt.
In other words, the D/E ratio compares a company’s equity — how much value is locked up in its shares — to its debts. What are liabilities? The most common types of debt are loans and accounts payable.
Among other things, knowing the D/E ratio can help investors gauge a company’s ability to cover what it owes. For example, if a company were to liquidate its assets, would it be able to cover its liabilities? How much money would be left over for shareholders?
The D/E ratio also indicates potential profitability to investors, because after a company makes its principal and interest payments, the remaining profits can be retained by shareholders as dividends or buybacks.
If a company is overleveraged and can’t cover its debts, if the company goes under, its shares could end up worthless.
Understanding Financial Leverage
To understand the debt-to-equity ratio, it’s important to understand the concept of leverage. A business has two options when it comes to paying for operating costs: It can either use equity (e.g., issuing shares, reinvesting profits), or it can use debt (leverage) and borrow money through the use of loans, bonds, or credit.
All together, these are referred to as a company’s capital structure: how it funds operations.
Debt can be a powerful aid for company growth, but it also introduces risk. It allows companies to:
• Expand operations (buy equipment, inventory, or other assets)
• Invest in research or technology
• Acquire competitors
• Smooth out cash flow during downturns
But leverage cuts both ways. While it can amplify returns when things go well, it also magnifies losses when they don’t. A company with high leverage must consistently generate enough cash to pay interest on its debts, repay the principal, and maintain operations.
Types of Debt
While it’s potentially risky to use leverage — a company might have to declare bankruptcy if it can’t pay its debt — borrowed funds can also help a company grow beyond the limitation of its equity at critical junctures.
Not all debt is considered equally risky, however, and investors may want to consider a company’s long-term versus short-term liabilities when investing, either through an online stock broker or a traditional one. Generally speaking, short-term liabilities (e.g. accounts payable, wages, etc.) that would be paid within a year are considered less risky.
A company’s ability to cover its long-term obligations is more uncertain, and is subject to a variety of factors including interest rates (more on that below).
The Debt-to-Equity (D/E) Ratio Formula
Calculating the debt-to-equity ratio is fairly straightforward. It helps to know how to read a balance sheet, which is filed with the Securities and Exchange Commission (SEC). The balance sheet has the numbers you need.
To calculate the D/E ratio, take the company’s total liabilities and divide that by shareholder equity. Here’s what the debt to equity ratio formula looks like:
D/E = Total Liabilities / Shareholder Equity
How to Calculate D/E: Step by Step
In order to calculate the debt-to-equity ratio, you need to understand both components.
Total Liabilities
This component includes a company’s current and long-term liabilities. Current liabilities are the debts that a company will typically pay off within the year, including accounts payable. Long-term liabilities are debts whose maturity extends longer than a year. Think mortgages on buildings or long-term leases.
Understanding the mix matters. A company heavily reliant on short-term debt may face more immediate pressure than one with long-term obligations.
Equity
The equity component includes two portions: shareholder equity and retained earnings. Shareholder equity is the money investors have paid in exchange for shares of the company stock.
Retained earnings are profits that the company holds onto that aren’t paid out in the form of dividends to shareholders.
Excel Formula for Debt-to-Equity Ratio
Using excel or another spreadsheet to calculate the D/E is relatively straightforward. First, using the company balance sheet, pull the total debt amount and the total shareholder equity amount, and enter these numbers into adjacent cells (e.g. E2 and E3).
Then, in cell E4 enter the formula “=E2/E3”, and this will give you the D/E ratio. This makes it easy to compare multiple companies side by side.
Real World Example of a D/E Calculation
To look at a simple example of a debt to equity formula, consider a company with total liabilities worth $100 million dollars and equity worth $85 million. Divide $100 million by $85 million and you’ll see that the company’s debt-to-equity ratio would be about 1.18. In other words, for every dollar of equity the company has $1.18 in debt.
When using a real-world debt-to-equity ratio formula, you’ll probably be able to find figures for both total liabilities and shareholder equity on a company’s balance sheet. Publicly traded companies will usually share their balance sheet along with their regular filings with the SEC.
Remember that arriving at this ratio is just that: a single number that reveals a certain aspect of a company’s potential performance, but doesn’t tell the whole story. It’s essential to compare a company’s D/E ratio to that of other companies in its industry.
In addition, there are many other ways to assess a company’s fundamentals and performance to help trade stocks online — by using fundamental analysis and technical indicators. Experienced investors rarely rely on one measure to evaluate a stock.
Interpreting the D/E Ratio
Once you’ve calculated a debt-to-equity ratio, it’s important to view it as part of a large context about the company’s fundamentals. While a D/E ratio of 1.0 may indicate a balance of debt to equity, it varies by company and industry.
High vs. Low D/E Ratios
A high D/E ratio indicates heavier reliance on debt, which can make a company more vulnerable during downturns. A company with a higher D/E ratio may deliver higher returns, but with greater risk exposure.
A lower D/E Indicates more conservative financing, which is lower risk, but it may suggest missed opportunities for growth.
Short-Term vs. Long-term Debt Considerations
If a company, such as a manufacturer, requires a lot of capital to operate, it may need to take on debt to finance its operations. A company like this may have a debt equity ratio of about 2.0 or more.
Other companies that might have higher ratios include those that face little competition and have strong market positions, and regulated companies, like utilities, that investors consider relatively low risk.
Companies that don’t need a lot of debt to operate may have debt-to-equity ratios below 1.0. For example, the service industry requires relatively little capital.
Modifying the Debt-to-Equity Ratio
As noted above, it’s also important to know which type of liabilities you’re concerned about — longer-term debt vs. short-term debt — so that you plug the right numbers into the formula. Analysts can dig deeper into the D/E ratio by comparing these numbers.
For example, if you have two companies, each with $2.5 million in shareholder equity, and $2.5 million in debt, their D/E ratios would be the same: 1.0.
But let’s say Company A has $2 million in long-term liabilities, and $500,000 in short-term liabilities, whereas Company B has $1.5 million in long-term debt and $1 million in short term debt. The long-term D/E ratio for Company A would be 0.8 vs. 0.6 for company B.
The numbers aren’t that far apart — but the higher amount of long-term debt for Company B is concerning, given the expense of covering long-term debt payments.
Recommended: How to Use Fundamental Analysis
What the D/E Ratio Tells Investors
A debt-to-equity-ratio that’s high compared to others in a company’s given industry may indicate that that company is overleveraged and in a precarious position. Given the cost of capital, servicing high levels of debt means that there’s less cash to invest in operations, or reallocate to shareholders via dividends.
Also, debt should be a concern for most investors because common stock shareholders are the last to be repaid if a company defaults on its debts.
Not only that, companies with a high debt-to-equity ratio may have a hard time working with other lenders, partners, or even suppliers, who may be afraid they won’t be paid back.
In some cases, creditors limit the debt-to-equity ratio a company can have as part of their lending agreement. Such an agreement prevents the borrower from taking on too much new debt, which could limit the original creditor’s ability to collect.
It is possible that the debt-to-equity ratio may be considered too low, which is an indicator that a company is relying too heavily on its own equity to fund operations. In that case, investors may worry that the company isn’t taking advantage of potential growth opportunities.
Ultimately, businesses must strike an appropriate balance within their industry between financing with debt and financing with equity.
What Does It Mean for a D/E Ratio to Be Negative?
A negative D/E ratio can be serious as it indicates negative shareholder equity, and that the company’s liabilities exceed its assets. So, what does this mean for investors?
Negative D/E ratios indicate to investors that the company is a higher investment risk and that the company is not financially stable. Therefore, investing in such a company may result in a loss for investors.
Average D/E Ratios by Industry
Typical debt-to-equity ratios vary by industry, because different industries operate with very different capital needs.
Capital-Intensive Industries (Utilities, Manufacturing)
Industries like utilities or manufacturing can be more capital intensive because they rely on expensive infrastructure and thus may rely on borrowing to cover the cost of assets.
The depository industry (banks and lenders) may have high debt-to-equity ratios. Because banks borrow funds to loan money to consumers, financial institutions usually have higher debt-to-equity ratios than other industries.
Other industries with high debt-to-equity ratios include:
• Non-depository credit institutions
• Insurance providers
• Hotels, rooming houses, camps, and other lodging places
• Air transportation
• Railroad transportation
Service and Tech Sectors
By contract, service and tech sectors tend to have lower capital requirements, and thus lower D/E ratios.
• Software
• Internet, digital content
• Gaming
• Chemicals
• Energy (e.g., oil and gas production)
• Healthcare, medical supplies
Effect of Debt-to-Equity Ratio on Stock Price
The debt-to-equity ratio can clue investors in on how stock prices may move. As a measure of leverage, debt-to-equity can show how aggressively a company is using debt to fund its growth.
The interest rates on business loans can be relatively low, and are tax deductible. That makes debt an attractive way to fund business, especially compared to the potential returns from the stock market, which can be volatile. And sometimes an aggressive strategy can pay off.
For example, if a company takes on a lot of debt and then grows very quickly, its earnings could rise quickly as well. If earnings outstrip the cost of the debt, which includes interest payments, a company’s shareholders can benefit and stock prices may go up.
The opposite may also be true. A highly leveraged company could have high business risk. If earnings don’t outpace the debt’s cost, then shareholders may lose and stock prices may fall.
Having to make high debt payments can leave companies with less cash on hand to pay for growth, which can also hurt the company and shareholders. And a high debt-to-equity ratio can limit a company’s access to borrowing, which could limit its ability to grow.
Debt-to-Equity (D/E) Ratio vs Gearing Ratio
The debt-to-equity ratio belongs to a family of ratios known as gearing ratios that investors can use to help them evaluate an organization’s use of leverage. These ratios are collectively known as gearing ratios.
Here’s a quick look at other gearing ratios you may encounter:
D/E Ratio vs. Equity Ratio
This ratio compares a company’s equity to its assets, showing how much of the company’s assets are funded by equity. The formula here is:
Equity ratio = Equity / Assets
D/E Ratio vs. Debt Ratio
This looks at the total liabilities of a company in comparison to its total assets. On the surface, this may sound like the debt ratio formula is the same as the debt-to-equity ratio formula. However, the total debt ratio formula includes short-term assets and liabilities as part of the equation, which the debt-to-equity ratio discounts.
Also, this ratio looks specifically at how much of a company’s assets are financed with debt.
Debt Ratio = Total Debt / Total Assets
Recommended: Calculating Return on Equity
Why Companies Monitor Their D/E Ratios
Businesses pay as much attention to debt-to-equity as individual investors. For example, if a company wants to take on new credit, they would likely want their debt-to-equity ratio to be favorable.
Banks and other lenders keep tabs on what healthy debt-to-equity ratios look like in a given industry. A debt-to-equity ratio that seems too high, especially compared to a company’s peers, might signal to potential lenders that the company isn’t in a good position to repay the debt.
Publicly traded companies that are in the midst of repurchasing stock may also want to control their debt-to-equity ratio. That’s because share buybacks are usually counted as risk, since they reduce the value of stockholder equity. As a result the equity side of the equation looks smaller and the debt side appears bigger.
While acceptable D/E ratios vary by industry, investors can still benefit from understanding how the debt-to-equity ratio plays a role in assessing the company’s risk.
Many companies borrow money to maintain business operations — making it a typical practice for many businesses. For companies with steady and consistent cash flow, repaying debt happens rapidly. Also, because they repay debt quickly, these businesses will likely have solid credit, which allows them to borrow inexpensively from lenders.
Therefore, even if such companies have high debt-to-equity ratios, it doesn’t necessarily mean they are risky. For example, companies in the utility industry must borrow large sums of cash to purchase costly assets to maintain business operations. However, since they have high cash flows, paying off debt happens quickly and does not pose a huge risk to the company.
On the other hand, companies with low debt-to-equity ratios aren’t always a safe bet, either. For example, a company may not borrow any funds to support business operations, not because it doesn’t need to but because it doesn’t have enough capital to repay it promptly. This may mean that the company doesn’t have the potential for much growth.
Analyzing IPOs Using the D/E Ratio
Many startups make high use of leverage to grow, and even plan to use the proceeds of an initial public offering, or IPO, to pay down their debt.
Of course, the results of their IPO will determine their debt-to-equity ratio, as investors put a value on the company’s equity, and thus their ability to offset debt.
So in the case of IPO investing, it’s important for investors to consider a company’s debt, and read the prospectus carefully, when deciding whether they want to buy IPO stock.
The Limitations of Debt-to-Equity Ratios
Debt-to-equity ratio is just one piece of the puzzle when it comes to evaluating stocks. Whether the ratio is high or low is not the bottom line of whether one should invest in a company. A deeper dive into a company’s financial structure can paint a fuller picture.
A company’s accounting policies can change the calculation of its debt-to-equity. For example, preferred stock is sometimes included as equity, but it has certain properties that can also make it seem a lot like debt. Specifically, preferred stock, with dividend payments included as part of the stock agreement, can cause the stock to take on some characteristics of debt, since the company has to pay dividends in the future.
If preferred stock appears on the debt side of the equation, a company’s debt-to-equity ratio may look riskier. If it’s included on the equity side, the ratio can look more favorable.
In some cases, companies can manipulate assets and liabilities to produce debt-to-equity ratios that are more favorable.
Additionally, investors may want to keep an eye on interest rates. If they’re low, it can make sense for companies to borrow more, which can inflate the debt-to-equity ratio, but may not actually be an indicator of bad tidings.
Finally, the debt-to-equity ratio does not take into account when a debt is due. A debt due in the near term could have an outsized effect on the debt-to-equity ratio.
As a result of temporary imbalances like these, investors may want to compare debt-to-equity ratios from various time periods to get an idea of a company’s ongoing capital structure, or whether fluctuations are signaling more noteworthy movement within the company.
The Takeaway
Investors can use the debt-to-equity (D/E) ratio to help determine potential risk before they buy a stock. As an individual investor you may choose to take an active or passive approach to investing. The approach investors choose may depend on their goals and personal preferences.
Investors who want to take a more hands-on approach to investing, choosing individual stocks, may take a look at the debt-to-equity ratio to help determine whether a company is a risky bet.
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FAQ
What is considered a moderate debt-to-equity ratio?
A D/E ratio of 1.0 simply means that a company’s debt and equity are in equal proportion; but that isn’t a reliable indicator of the company’s health. To know whether the D/E ratio is acceptable for a given company, you have to consider the industry, competitors, as well as other aspects of the business.
How do you interpret debt-to-equity ratio?
Taking a broader view of a company and understanding the industry it’s in and how it operates can help to correctly interpret its D/E ratio. For example, utility companies might be required to use more leverage to purchase assets to maintain business operations. But utility companies have steady inflows of cash, and for that reason having a higher D/E may not spell higher risk.
What is considered a debt-to-equity ratio that’s not aligned with industry averages?
A D/E ratio of about 1.0 to 2.0 is considered acceptable, depending on other factors like the industry the company is in. But a D/E ratio above 2.0 — i.e., more than $2 of debt for every dollar of equity — could be a red flag. Again, context is everything and the D/E ratio is only one indicator of a company’s health.
Can a company have too little debt?
It depends on the company and the industry. When a company has a low D/E ratio, and lower use of leverage, that means it finances its operation more through equity than by borrowing. That could indicate a conservative business model, and relative stability — or it could indicate the company isn’t seeking new, efficient ways to grow.
Where do I find the numbers to calculate the D/E ratio?
By reading a company’s balance sheet, which is filed with the SEC, you can find the total liabilities as well as shareholder equity.
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