Table of Contents:
- Debt-to-equity ratio formula
- What’s a good debt-to-equity ratio?
- What does a high debt-to-equity ratio mean?
- Why does debt-to-equity ratio matter?
- The Bottom Line
When investing as a beginner, market conditions, such as whether it’s a bull vs. bear market can have an impact on the decisions you make, so it’s important to gain insight on how you can be affected.
One of the things you’ll want to look at is how financially stable a company is, and one way to do that is to examine its debt-to-equity ratio. You’re probably wondering what the debt-to-equity ratio (D/E ratio) is and why it’s important.
A debt to equity ratio measures the extent to which a company can cover its debt. It highlights the connection between the assets that are financed by the shareholders vs. by lenders.
The debt-to-equity ratio is a capital structure metric, which means that a company uses a combination of debt and equity to finance its overall growth and operations. In other words, it’s used to assess the extent that the company relies on loans for normal operations vs. funds on hand. It’s important because it shows the company’s ability to utilize shareholder equity to pay pending debts in case the business hits a rough patch.
- The debt-to-equity ratio evaluates a company’s equity and liabilities to determine the amount of leverage the company uses to operate.
- Although high ratios can be a red flag, that’s not always the case, so additional factors such as trends in the market should be looked at before making that determination.
- Some industries tend to have higher debt-to-equity ratios, and the amount of debt can vary greatly among different industries.
Debt-to-equity ratio formula
When calculating the debt-to-equity ratio, we look at the company’s balance sheet, which is the financial statement of what the company owes and owns. This includes long-term debts and what is owned outright in equity.
Because the balance sheet may contain categorized items not considered as debt or equity, it can be difficult to see what the company’s leverage is. Because of this, analysts may need to modify or adjust ratios.
The financial statement discloses assets and liabilities as well as the shareholder’s equity, which are the assets left after all debts have been paid. Reviewing it, along with any additional financial information, can give a well-rounded picture of the company’s financial stability.
The debt-to-equity ratio formula is:
D/E = Total debt / Total shareholder’s equity
For example, company A has $200,000 in debt / $100,000 in shareholder’s equity = 2 D/E ratio. This means for every $1.00 the shareholders own, the business owes $2.00 to its creditors.
To find a company’s leverage, you need to figure out their total capital, which includes all debt with interest and the shareholder’s equity, which can be in the form of stocks.
The formula is:
Debt-to-capital ratio = Total debt / (Total debt + Shareholders equity)
Debt-to-equity ratio and gearing ratio
When a company is looking to grow and expand, it will evaluate the advantages and disadvantages of both using its assets to leverage growth vs. borrowing to do it. As a stockholder, your goal is to invest in financially stable companies, and gearing ratios can help you in determining which companies are financially secure from those that are not.
Gearing ratios describe a variety of financial ratios, one of which is the debt-to-equity ratio. They are used by various companies and professionals to evaluate the financial adequacy of their borrowers. The term “gearing” refers to financial leverage and is more of a theoretical concept, not a precise calculation and is open to interpretation.
To utilize the debt-to-equity ratio, it’s vital to understand that it is meant to compare companies in the same industries. Big differences in ratios among similar companies can alert investors to dig deeper and find out the cause of the discrepancy before buying stocks in that company.
What’s a good debt-to-equity ratio?
Debt-to-equity ratios are not a one-size-fits-all formula and are dependant on a variety of factors. When considering what’s a safe debt-to-equity ratio, it’s important to take into consideration the nature of the business as well as the industry.
As a general rule, most businesses would be considered financially stable with a debt-to-equity ratio below 1.0, but the higher you go, the riskier it becomes. For example, 2.0 or more is considered a high debt-to-equity ratio and could be considered a much greater risk.
Some companies may have what’s called a negative D/E ratio, meaning they have a lot of debt with negative equity. They are considered to be a big risk for investors, as the negative debt-to-equity ratio can be a sign that the company may be at risk for bankruptcy.
What does a high debt-to-equity ratio mean?
When it comes to looking at debt-to-equity ratio, it’s important to understand that there are certain businesses where it’s normal to have a high D/E ratio due to the nature of that particular industry.
Some businesses need to borrow money in order to do business. You see this in the financial sector where banks and loan companies borrow in order to lend. They have higher debts because of this. Other industries in similar situations include manufacturing, utilities, airlines, and other transportation business models.
For these businesses, a higher debt-to-equity ratio is expected. Otherwise, it could signal problems with the company.
High D/E ratio benefits
Although we generally see a high D/E ratio as a negative, there are some benefits for companies, including the following:
- A high D/E ratio could convey that a business is confident it can pay its debts due to a steady cash flow and increased growth and equity returns.
- Using debt can help fuel growth, thus potentially increasing revenue
- Raising debt can help a company that would not otherwise be able to afford to grow or expand its products and services.
High debt-to-equity ratio limitations
As stated earlier, there are both pros and cons to a high debt-to-equity ratio and depending on the circumstances and industry, some limitations may include:
- When evaluating a company’s debt-to-equity ratio, it’s important to consider the industry as some need more capital than others in order to do business, such as banking and utilities. Investors may not grasp that slow growth industries may have high leverage ratios that represent an efficient use of capital.
- Potential investors may mistakenly assume that a company is being mismanaged due to a higher debt-to-equity ratio despite industry standards.
- How analysts define debt may not be consistent, since some industries have high revolving debt to operate.
Why does debt-to-equity ratio matter?
Since the D/E ratio is used to evaluate a company’s capitalization and how much debt it’s taking on to leverage assets, a higher ratio is usually associated with higher risk.
The key is using debt for growth purposes in order to produce more income than the debt costs. For many companies, growth wouldn’t happen without the use of credit to finance it. Share values rise if leverage has generated more earnings than the cost of the debt, but if the costs outweigh the earnings, values can decline. Since interest rates change over time, it can be risky to borrow in some cases.
Short-term debt doesn’t have as big of an impact as long-term debt does on the debt-to-equity ratio, as short-term debt obligations can be managed and recorded more easily. Long-term debt accounts are much larger and offer a more significant impact.
Also, not all industries are created equal when it comes to debt and how it’s leveraged. There are a variety of industries that require more debt just to run the business and are known as capital-intensive industries. They require debt to produce the products and services that earn income for their businesses and without it, they wouldn’t have a business.
Banking and financial industries lend money and need to have large amounts of capital to do so. The telecommunications industry needs large amounts of capital for installing miles of cable lines to provide their service as well as providing maintenance. They also have upgrades, expansion, and additional services to manage, and without capital, these services couldn’t be provided. Utilities are another capital-intensive business that can’t operate without large amounts of capital.
Banking, too, is one of the most capital-intensive businesses with very high debt-to-equity ratios. However, since the risks are low, the ratio can be misleading as banks operate with a high level of financial leverage. Higher ratios are normal for them, and they are not alone. Larger manufacturers like utilities, airlines, and other transportation companies also have high debt-to-equity ratios, which is considered the industry standard.
The bottom line
The debt-to-equity ratio is used to evaluate how a company uses finances to manage its business with debt vs. equity. Each industry has its own standards of need and what is deemed as a positive or negative debt-to-equity ratio for generating income for that business.
As a rule, the lower the debt-to-equity ratio, the better. It shows the company is financially sound and able to manage debt to manage growth and leverage capital, though that’s not always the case, so it’s important to understand how debt-to-equity ratios can affect your decisions.