What is the debt-to-equity ratio?

TL;DR

  • The debt-to-equity ratio is used to analyze the amount of debt a company holds compared to its shareholder equity.
  • The debt-to-equity ratio is calculated by dividing a company’s total debt by its shareholder equity.
  • A relatively high debt-to-equity ratio tells an investor that the company relies heavily on debt to finance operations and expansion.
  • A relatively low debt-to-equity ratio tells an investor that the company does not rely on borrowing a lot of money to finance operational activity.
  • A company’s debt-to-equity ratio, independent of its peers, can be very misleading.

What is a debt-to-equity ratio?

Debt is an essential piece of any business. Many companies rely on debt to fund expansion and generate greater income. That being said, the amount of debt a company takes on is very indicative of its overall health; too little or too much debt could signal a risky investment. When analyzing the amount of debt a company holds, investors will often refer to something called the debt-to-equity ratio. As the name implies, this ratio compares a company’s total debt to its shareholder equity. By doing so, investors can assess how “leveraged” a company is, or rather, how much they are relying on debt to generate future returns.

Debt-to-equity ratio calculations

In general, the debt-to-equity ratio is calculated by dividing a company’s total debt by its shareholder equity. That being said, some investors will include only certain pieces of debt in the numerator of the calculation. Therefore, it is important to understand what makes up total debt and shareholder equity before blindly calculating the ratio.

When someone mentions the term “total debt,” she is referring to the total liabilities that sit on a company’s balance sheet. A liability can be classified as either current or non-current. Liabilities classified as current are usually obligations that are due within the year. The sum of a company’s liabilities is often found near the bottom of the balance sheet and this is the number that should be used in the numerator of the debt-to-equity formula. That being said, some people remove short-term debt from the calculation if they are more concerned with a company’s ability to pay off long-term borrowings.

Also on a company’s balance sheet, is shareholder equity. Shareholder equity is made up of two components: retained earnings and share capital. Retained earnings represent any profit that is reinvested back into the business instead of distributed to shareholders in the form of dividends. Share capital is the value of outstanding shares in the stock market. Together they represent the value of a company after all debts are paid off. Shareholder equity is the number that should be used in the denominator of the debt-to-equity formula.

Here is an example of how to calculate the debt-to-equity ratio of a company. As mentioned, both total debt and shareholder equity can be identified on a company’s balance sheet, which is reported in quarterly and annual reports. If total debt is identified on the balance sheet to be $150 billion and total equity is identified to be $85 billion, you would simply divide $150 billion by $85 billion to get a debt-to-equity ratio of 1.76. But what does 1.76 mean to an outside investor?

How to understand the debt-to-equity ratio

Interpreting the debt-to-equity ratio is crucial in assessing a company’s financial health. While it is always important to compare a company’s ratio to its industry peers, there are general rules that guide what is defined as a “good” or “bad” debt-to-equity ratio.

Most investors suggest that a company’s debt-to-equity ratio should not be higher than 2. This is because a high ratio may signal to investors that the company has taken on a lot of debt and could be incapable of paying it off. On the other hand, an extremely low debt-to-equity ratio can be seen as equally troublesome. A very low ratio indicates to investors that the company does not use debt to finance operations, which could limit profits in the long run. If a company’s debt-to-equity ratio is below 1, it may start returning cash to shareholders in the form of dividends, to increase their ratio. Another sign of potential financial instability is a negative debt-to-equity ratio. A negative ratio usually occurs when a company’s shareholder equity is negative. Negative shareholder equity is usually the result of several periods of accumulated losses or large dividend payments that depleted retained earnings. Regardless of the root cause, a negative debt-to-equity ratio is often a sign of financial distress and should be taken seriously by interested investors.

As always in investing, there are exceptions to the general rules mentioned above. It is important to compare a company’s debt-to-equity ratio to its industry average because what is considered normal in one industry may be concerning in another. For example, some industries, such as manufacturing, are known to have higher debt-to-equity ratios. Therefore, a typically high ratio, under these circumstances, shouldn’t raise concerns. Always compare a company’s debt-to-equity ratio to its peers before drawing a conclusion.

Bottom line

The debt-to-equity ratio is a great measure of how much debt a company is using to finance its operations. The debt-to-equity calculation is fairly simple, but understanding what the ratio means is more complicated. For the most part, industry standards define what a “good” or “bad” debt-to-equity ratio is. A company’s debt-to-equity ratio, independent of its peers, can be very misleading. A relatively high or low debt-to-equity ratio could raise concerns about how a company is financed and its ability to pay off debt or generate returns. Therefore, it is important to analyze this key metric when determining if a company is financially healthy and worth investing in.

Courtney is a freelance writer and finance professional based out of New York City. You can connect with her on Twitter at @CourtSaintJames.

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