Debt-to-equity ratio (D/E) is a metric used in corporate finance to evaluate a company’s financial leverage. It is calculated by dividing a company’s total liabilities by its shareholder equity. Debt-to-equity ratio measures to what level a company is financing its operations through debt versus owned funds.
It also reflects whether shareholder equity could be used to cover all outstanding debts if there was a business downturn. Higher-leverage ratios indicate that a company or stock presents a greater risk to shareholders.
It can be difficult to compare the debt-to-equity ratio across industry groups where amounts of acceptable debt will vary. It is also important to mention that some investors will modify debt-to-equity ratio to only include long-term debts, as short-term debts are deemed less of a risk.
How debt-to-equity ratio works
The debt-to-equity ratio is calculated by dividing a company’s total liabilities by its shareholder equity, both of which can be found on the company’s balance sheet. For example, if a company has total liabilities equalling $13.1 billion in debt and total shareholder equity of $8.79 billion it would have a debt to equity ratio of 1.49.
A high ratio can indicate that the company has been aggressive in financing its growth with debt and is therefore highly leveraged and presents a higher risk. What is considered as a good debt-to-equity ratio varies greatly depending on the nature of the business and its industry.
Typically, a debt-to-equity ratio of below 1.0 would be seen as relatively safe, whereas ratios of 2.0 would be deemed high risk.
But these rules cannot always be applied. For example, industries such as banking and the financial services sector are known for having a much higher debt-to-equity ratio and one that is too low may actually be a warning signal that the company isn’t taking advantage of debt financing to expand and grow.
Advantages of debt to equity ratio
The advantages of debt to equity ratio include:
Indicative of residual profit
Calculating a company’s debt-to-equity ratio tells an investor how much debt is present in comparison to the amount of equity. This can then be used to determine how much profit will be available for equity holders as they only have the residual claim over the profits of the company.
The debt-to-equity ratio can help investors analyse the level of risk the company represents as an investment opportunity. The higher the D/E the higher the risk, using this metric can help investors manage their exposure to risk.
Disadvantages of debt to equity ratio
The disadvantages of debt to equity ratio include:
Companies that have a volatile market price or debt price can be harder to calculate debt to equity ratio and may require smoothening, which is an estimated process and may not be particularly accurate.
Can be difficult to compare
From multiple ways to calculate debt-to-equity ratio to the difference in acceptable levels of debt across industries can make it hard to use D/E to compare different investment opportunities.