What Is the Debt-To-Equity Ratio – D/E?
The Debt to Equity ratio is an important metric used in corporate finance. It is a measure of the degree to which a company is financing its operations through debt versus wholly-owned funds.
The debt-to-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. More specifically, it reflects the ability of shareholder equity to cover all outstanding debts in the event of a business downturn.
Leverage refers to the amount of debt incurred for the purpose of investing and obtaining a higher return.
D/E Ratio Formula and Calculation
The information needed for the D/E ratio is on a company’s balance sheet.
Given that the debt-to-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 ratio is often associated with high risk; it means that a company has been aggressive in financing its growth with debt.
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.
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 make 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 riskier. Including preferred stock in the equity portion of the D/E ratio will increase the denominator and lower the ratio.
Limitations of the D/E 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.
Utility 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 a relatively stable income.
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