To get a clearer picture and facilitate comparisons, analysts and investors will often modify the D/E ratio. They also assess the D/E ratio in the context of short-term leverage ratios, profitability, and growth expectations. These balance sheet categories may include items that would not normally be considered debt or equity in the traditional sense of a loan or an asset.
Liabilities and shareholder equity can be found on the balance sheet, which is a financial statement that lists a company’s assets, liabilities and stockholders’ equity at a particular point in time. When evaluating a company’s financial health, you can use several liquidity ratios. One is the debt-to-equity (D/E) ratio, which compares total liabilities to total shareholder equity.
- The Debt-to-Equity ratio (D/E ratio) is a financial metric that compares a company’s total debt to its shareholders’ equity, representing the extent to which debt is used to finance assets.
- Investors can benefit if leverage generates more income than the cost of the debt.
- This ratio highlights how a company’s capital structure is tilted either toward debt or equity financing.
- Some investors also like to compare a company’s D/E ratio to the total D/E of the S&P 500, which was approximately 1.58 in late 2020 (1).
- Therefore, the overarching limitation is that ratio is not a one-and-done metric.
Typical debt-to-equity ratios vary by industry, but companies often will borrow amounts that exceed their total equity in order to fuel growth, which can help maximize profits. A company with a D/E ratio that exceeds its industry average might be unappealing to lenders or investors turned off by the risk. As well, companies with D/E ratios lower than their industry average might be seen as favorable to lenders and investors. The debt-to-equity ratio is calculated by dividing a company’s total liabilities by its total shareholder equity.
A high ratio may indicate the company is more vulnerable to economic downturns or interest rate fluctuations, while a low ratio may suggest financial stability and flexibility. https://www.quick-bookkeeping.net/5-5-cost-volume-profit-analysis-in-planning/ Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.
As you can see, company A has a high D/E ratio, which implies an aggressive and risky funding style. Company B is more financially stable but cannot reach the same levels of ROE (return on equity) as company A in the case of success. Determining whether a debt-to-equity ratio is high or low can be tricky, as it heavily depends on the industry.
Debt-to-Equity Ratio Formula
The debt-to-equity ratio reveals how much of a company’s capital structure is comprised of debts, in relation to equity. An investor, company stakeholder, or potential lender may compare a company’s debt-to-equity ratio to historical levels or those of peers. Restoration Hardware’s cash flow from operating activities has consistently grown over the past three years, suggesting the debt is being put to work and is driving results. Additionally, the growing cash flow indicates that the company will be able to service its debt level. As an example, the furnishings company Ethan Allen (ETD) is a competitor to Restoration Hardware. The 10-K filing for Ethan Allen, in thousands, lists total liabilities as $312,572 and total shareholders’ equity as $407,323, which results in a D/E ratio of 0.76.
The D/E ratio is much more meaningful when examined in context alongside other factors. Therefore, the overarching limitation is that ratio is not a one-and-done metric. The investor has not accounted for the fact that the utility company receives a consistent and durable stream of income, so is likely able to afford its debt. When assessing D/E, it’s also important to understand the factors affecting the company.
Why are D/E ratios so high in the banking sector?
If both companies have $1.5 million in shareholder equity, then they both have a D/E ratio of 1. On the surface, the risk from leverage is identical, but in reality, the second company is riskier. Companies finance their operations and investments with a combination of debt and equity. Debt in itself isn’t bad, and companies who don’t make use of debt financing can potentially place their firm at a disadvantage. The D/E ratio indicates how reliant a company is on debt to finance its operations. It’s useful to compare ratios between companies in the same industry, and you should also have a sense of the median or average D/E ratio for the company’s industry as a whole.
If the debt to equity ratio gets too high, the cost of borrowing will skyrocket, as will the cost of equity, and the company’s WACC will get extremely high, driving down its share price. In the example below, we see how using more debt (increasing the debt-equity ratio) increases the company’s return on equity (ROE). By using debt instead of equity, the equity account is smaller and therefore, return on equity is higher. When looking at a company’s balance sheet, it accrued revenues is important to consider the average D/E ratios for the given industry, as well as those of the company’s closest competitors, and that of the broader market. A company that does not make use of the leveraging potential of debt financing may be doing a disservice to the ownership and its shareholders by limiting the ability of the company to maximize profits. A D/E ratio of 1.5 would indicate that the company in question has $1.50 of debt for every $1 of equity.
To get a sense of what this means, the figure needs to be placed in context by comparing it to competing companies. Of note, there is no “ideal” D/E ratio, though investors generally like it to be below about 2. We’ll now move to a modeling exercise, which you can access by filling out the form below. Lenders and investors perceive borrowers funded primarily with equity (e.g. owners’ equity, outside equity raised, retained earnings) more favorably.
What is debt-to-equity ratio?
Lenders and debt investors prefer lower D/E ratios as that implies there is less reliance on debt financing to fund operations – i.e. working capital requirements such as the purchase of inventory. In general, if a company’s D/E ratio is too high, that signals that the company is at risk of financial distress (i.e. at risk of being unable to meet required debt obligations). If a company has a D/E ratio of 5, but the industry average is 7, this may not be an indicator of poor corporate management or economic risk. There also are many other metrics used in corporate accounting and financial analysis used as indicators of financial health that should be studied alongside the D/E ratio. On the other hand, the typically steady preferred dividend, par value, and liquidation rights make preferred shares look more like debt.
Conversely, a lower ratio indicates a firm less levered and closer to being fully equity financed. The D/E ratio can be classified as a leverage ratio (or gearing ratio) that shows the relative amount of debt a company has. As such, it is also a type of solvency ratio, which estimates how well a company can service its long-term debts and other obligations. This is in contrast to a liquidity ratio, which considers the ability to meet short-term obligations. This ratio compares a company’s total liabilities to its shareholder equity. It is widely considered one of the most important corporate valuation metrics because it highlights a company’s dependence on borrowed funds and its ability to meet those financial obligations.
Investors can use the D/E ratio as a risk assessment tool since a higher D/E ratio means a company relies more on debt to keep going. Get instant access to lessons taught by experienced private equity pros and bulge bracket investment bankers including financial statement modeling, DCF, M&A, LBO, Comps and Excel Modeling. A negative shareholders’ equity results in a negative D/E ratio, indicating potential financial distress. For purposes of simplicity, the liabilities on our balance sheet are only short-term and long-term debt. However, a low D/E ratio is not necessarily a positive sign, as the company could be relying too much on equity financing, which is costlier than debt. Below is a short video tutorial that explains how leverage impacts a company and how to calculate the debt/equity ratio with an example.