You already know that some debt can help you meet your financial goals. Taking out a mortgage on your house, for example, or borrowing money to go to college and help build financial security.
Companies use debt, also known as leverage, to help them accomplish business goals and finance operating costs. The ratio used to measure this leverage is called the debt-to-equity ratio (D/E). Understanding how to use this debt-equity formula may help you when making investment decisions.
What Is the Debt-to-Equity Ratio?
The debt-to-equity ratio is one of several metrics that you can use to evaluate individual stocks. At its simplest, the debt-to-equity ratio measures how much debt it takes for a company to run its business.
It compares a company’s equity—how much value is locked up in its shares—to its debts. Another way of looking at it is as a measure of a company’s ability to cover its debts. For example, if a company were to liquidate its assets, would it be able to cover its debt? How much money would be left over for shareholders?
Investors often use the debt-to-equity ratio to determine how much risk a company has taken on and, in return, How risky it may be to invest in that company. After all, if a company goes under and can’t cover its debts, its shares could be worthless.
What Is Leverage?
To understand the debt-to-equity ratio, it’s helpful to understand the concept of leverage. A business has two options when it comes to paying for operating costs: It can either use equity or they can use debt, aka leverage.
The company can use the funds from this debt to buy equipment, inventory, or other assets or to fund new projects or acquisitions. It can also serve as working capital when cash flow is low in cyclical businesses.
.While it’s potentially risky to use leverage—a company might have to declare bankruptcy if it can’t pay its debt—it can also help a company grow beyond the limits of its equity.
The term “leverage” reflects the hope that the company will be able to use a relatively small amount of debt to boost its growth and earnings. Wise use of debt can help companies build a good reputation with creditors, which, in turn, will allow them to borrow more money for potential future growth.
The Debt-to-Equity Ratio Formula
Calculating the debt-to-equity ratio is pretty straightforward. An excellent first step is to take the company’s total liabilities and divide them by shareholder equity. Here’s what the debt-to-equity ratio formula looks like:
D/E = Total Liabilities / Shareholders’ Equity
Here’s a closer look at the two components of the equation:
Total Liabilities
This component includes a company’s current and long-term liabilities. Current liabilities are the debts that a company typically pays off within the year, including accounts payable. Long-term liabilities are debts whose maturity extends longer than a year. Think mortgages on buildings or long-term leases.
Equity
The equity component includes two portions: shareholder equity and retained earnings. Shareholder equity is the money investors have paid in exchange for shares of the company stock. Retained earnings are profits the company holds onto that aren’t paid out in the form of dividends to shareholders.
Debt-to-Equity Example
Consider a company with total liabilities worth 100 million dollars and equity worth $85 million to look at a simple example of a debt-to-equity formula. Divide $100 million by $85 million, and you’ll see that the company’s debt-to-equity ratio would be about 1.18.
When using a real-world debt-to-equity ratio formula, you’ll probably be able to find figures for both total liabilities and shareholder equity on a company’s balance sheet. Publicly traded companies usually share their balance sheet and regular filings with the Securities and Exchange Commission (SEC).
What Is a Good Debt-to-Equity Ratio?
Once you’ve calculated a debt-to-equity ratio, how do you know whether that number is good or bad? As a very general rule of thumb, an excellent debt-to-equity ratio will equal about 1.0. However, the acceptance rate varies by industry and may depend on the economy. For example, a higher debt-to-income ratio could be riskier in an economic downturn than during a boom.
For example, if a company, such as a manufacturer, requires a lot of capital to operate, it may need to take on a lot of debt to finance its operations. A company like this may have a debt-equity ratio of about 2.0 or more.
Other companies that might have high ratios include those with little competition and strong market positions, and regulated companies, like utilities, that investors consider relatively low risk.
Companies that don’t need a lot of debt to operate may have debt-to-equity ratios below 1.0. For example, the service industry requires relatively little capital.
What Does a Company’s Debt-to-Equity Ratio Mean?
A high debt-to-equity ratio compared to others in a company’s given industry may indicate that that company is overleveraged and in a precarious position. Investors may want to shy away from companies that are overloaded with debt. And not only that, companies with a high debt-to-equity ratio may have a hard time working with other lenders, partners, or even suppliers, who may be afraid they won’t be paid back.
In some cases, creditors limit the debt-to-equity ratio a company can have as part of its lending agreement. Such an agreement prevents the borrower from taking on too much new debt, which could limit the original creditor’s ability to collect.
The debt-to-equity ratio may also be considered too low, indicating that a company relies too heavily on its equity to fund operations. In that case, investors may worry that the company isn’t taking advantage of potential growth opportunities.
Ultimately, businesses must strike an appropriate balance within their industry between financing with debt and financing with equity.
What Does It Mean for a Debt-to-Equity Ratio to Be Negative?
There could be several reasons for a negative debt-to-equity ratio, including:
• Interest rates are higher than the returns
• A negative net worth (more liabilities than assets)
• A financial loss after a hefty dividend payout
• Dividend payments that surpass the investor’s equity in the firm
So, what does this mean for investors?
Negative debt-equity ratios may tell investors that the company indicates investment risk and shows that the company is not financially stable. Therefore, investing in such a company may result in a loss for investors.
Which Industries Have High Debt-to-Equity Ratios?
The depository industry (banks and lenders) had the highest debt-to-equity ratio in 2020. Because banks borrow funds to loan money to consumers, financial institutions usually have higher debt-to-equity ratios than other industries.
Other industries with high debt-to-equity ratios include:
• Non-depository credit institutions
• Insurance providers
• Hotels, rooming houses, camps, and other lodging places
• Transportation by air
• Railroad transportation
Effect of Debt-to-Equity Ratio on Stock Price
The debt-to-equity ratio can clue investors in on how stock prices may move. As a measure of leverage, debt-to-equity can show how aggressively a company uses debt to fund its growth.
The interest rates on business loans can be relatively low and are tax deductible. That makes the debt an attractive way to fund business, especially compared to the potential returns on the stock market. And sometimes, an aggressive strategy can pay off.
For example, if a company takes on a lot of debt and proliferates, its earnings could rise quickly. If earnings outstrip the cost of the debt, which includes interest payments, shareholders can benefit, and stock prices may go up.
The opposite may also be true. A highly leveraged company could have high business risk. If earnings don’t outpace the debt’s cost, shareholders may lose, and stock prices may fall.
I have to make high debt payments can leave companies with less cash on hand to pay for growth, which can also hurt the company and its shareholders. And a high debt-to-equity ratio can limit a company’s access to borrowing, limiting its ability to grow.
Debt-to-Equity (D/E) Ratio vs. the Gearing Ratio
The debt-to-equity ratio is a family of leverage ratios that investors can use to help them evaluate companies. These ratios are collectively known as gearing ratios.
Here’s a quick look at other gearing ratios you may encounter:
Equity Ratio
This ratio compares a company’s equity to its assets, showing how much of its assets are funded by equity.
Debt Ratio
This looks at the total liabilities of a company in comparison to its total assets. On the surface, this may sound like the debt ratio formula is the same as the debt-to-equity ratio formula. However, the total debt ratio formula includes short-term assets and liabilities as part of the equation, which the debt-to-equity ratio discounts. Also, this ratio looks at how much of a company’s assets are financed with debt.
Time Interest Earned
This ratio helps indicate whether a company can make interest payments on its debt, dividing earnings before interest and taxes (EBIT) by total interest. Most of the information needed to calculate these ratios appears on a company’s balance sheet, save for EBIT, which appears on its profit and loss statement.
How Businesses Use Debt-to-Equity Ratios
Businesses pay as much attention to debt-to-equity as individual investors. For example, if a company wants to take on new credit, it would likely want its debt-to-equity ratio to be favorable.
Banks and other lenders keep tabs on what healthy debt-to-equity ratios look like in a given industry. A debt-to-equity ratio that seems too high, especially compared to a company’s peers, might signal to potential lenders that the company isn’t in an excellent position to repay the debt.
Publicly traded companies in the midst of repurchasing stock may also want to control their debt-to-equity ratio. That’s because share buybacks are usually considered risks since they reduce the value of stockholder equity. As a result, the equity side of the equation looks smaller, and the debt side appears bigger.
How Can the Debt-to-Equity Ratio Be Used to Measure a Company’s Riskiness?
While acceptable debt-to-equity ratios vary by industry, investors can still use this ratio to identify companies they want to invest in. First, however, it’s essential to understand the scope of the industry to fully grasp how the debt-to-equity ratio plays a role in assessing the company’s risk.
Many companies borrow money to maintain business operations—making it a typical practice for many businesses. For companies with steady and consistent cash flow, repaying debt happens rapidly. Also, because they repay debt quickly, these businesses will likely have solid credit, which allows them to borrow inexpensively from lenders.
Therefore, even if such companies have high debt-to-equity ratios, it doesn’t necessarily mean they are risky. For example, companies in the utility industry must borrow large sums of cash to purchase costly assets to maintain business operations. However, since they have high cash flows, paying off debt happens quickly and does not pose a huge risk to the company.
On the other hand, companies with low debt-to-equity ratios aren’t always a safe bet, either. For example, a company may not borrow any funds to support business operations, not because it doesn’t need to but because it doesn’t have enough capital to repay it promptly. This may mean that the company doesn’t have the potential for much growth.
IPOs and Debt-to-Equity Ratios
Many startups use leverage to grow and even plan to use the proceeds of an IPO to pay down their debt. The results of their IPO will determine their debt-to-equity ratio, as investors put a value on the company’s equity. So investors need to consider debt when deciding whether to buy IPO stock.
The Limitations of Debt-to-Equity Ratios
The debt-to-equity ratio is just one piece of the puzzle in evaluating stocks. Whether the ratio is high or low is not the be-all and end-all of whether one should invest in a company. A deeper dive into a company’s financial structure can paint a fuller picture.
A company’s accounting policies can change the calculation of its debt-to-equity. For example, preferred stock is sometimes included as equity, but it has specific properties that can make it seem like debt. Specifically, preferred stock with dividend payments included as part of the stock agreement can cause the stock to take on some characteristics of debt since the company has to pay dividends in the future.
If a preferred stock appears on the debt side of the equation, a company’s debt-to-equity ratio may look riskier. The ratio can look more favorable if it’s included in equity.
In some cases, companies can manipulate assets and liabilities to produce debt-to-equity ratios that are more favorable. Additionally, investors may want to keep an eye on interest rates.
If they’re low, it can make sense for companies to borrow more, which can inflate the debt-to-equity ratio but may not indicate evil tidings. Finally, the debt-to-equity ratio does not consider when a debt is due. A debt due in the near term could have an outsized effect on the debt-to-equity ratio.
As a result of temporary imbalances like these, investors may want to compare debt-to-equity ratios from various periods to get an idea of a company’s average wage or whether fluctuations are signaling more unusual movement within the company.
The Takeaway
You may take an active or passive approach to invest and build a nest egg as an individual investor. The approach of investors may depend on their goals and personal preferences.
Investors comfortable with a passive, hands-off approach may want to invest through the index or exchange-traded funds, which provide a diversified portfolio through a basket of investments. Investors who want to take a more hands-on approach to invest, choosing individual stocks, may look at the debt-to-equity ratio to help determine whether a company is a risky bet.
