Debt-To-Equity Ratio – A Comprehensive Guide

An infographic explaining what the debt-to-equity ratio is, how it is calculated, and its limitations.

A company can finance its operations in two ways. One way is through debt, and the other way is through equity. Every company has a debt-to-equity ratio. It is a crucial financial metric that company stakeholders can use for various reasons.

Equity, also called shareholders’ equity, is what investors own in the company. For example, a publicly-traded company obtains equity by issuing stocks. In a small business, such as a sole proprietorship, the owner’s investment in the business is the shareholder’s equity.

Debt is money owed by one party to another. It usually has a negative connotation, and most people see it as something bad and something you need to avoid as much as possible. However, for most businesses, debt is a necessity and not all that bad. If a company uses its debt smartly, it can increase its profits significantly.  

The debt-to-equity ratio is very popular, and various groups of people use it for various reasons. For example, lenders often use it to evaluate if a company’s financial situation is stable enough to offer them loans. Investors can also use it as part of their analysis to evaluate if a company’s stock is a good investment.

Here is an overview of what this ratio is, how to calculate it, its use, and its limitations.

What Is the Debt-To-Equity Ratio?

The debt-to-equity ratio is a financial leverage ratio that indicates the relative proportion of total debt and shareholders’ equity that the company uses to finance its assets. Thus, the ratio shows how much debt a company has for every dollar of equity. 

Companies use leverage to finance their assets. Instead of issuing stocks to raise capital, companies can use debt to invest in business operations to increase shareholder value. When debt is the primary way a company finances its business, it is considered highly leveraged, and its debt-to-equity ratio will be high.

Leverage ratios are a group of ratios that determine a company’s dependence on debt instead of equity. The debt-to-equity ratio is a useful metric for stakeholders, especially for investors who want to calculate the company’s risk.

The debt-to-equity ratio, in its simplest form, is easy to understand. However, a thorough analysis of what debt and equity categories are included in calculating this ratio is crucial. Stakeholders often alter this ratio to fit their needs. In addition, a comparison of debt-to-equity ratios with similar companies in the same industry is necessary to understand this ratio for a particular company better.

How to Calculate the Debt-To-Equity Ratio?

The formula for the debt-to-equity ratio in its simplest form is:

The debt to equity ratio equals total liabilities divided by total shareholders' equity

Here is an example that shows 2 different companies with 2 different D/E ratios.

An infographic showing the d/e ratios of 2 different companies One with a D/E of 5 which would not be a good investment, the other one with a D/E of 1, which could be a good investment.

A debt/equity ratio of 5 means that the company uses $5 of debt financing for every $1 in equity financing. A debt-to-equity ratio of 1 means that the company uses $1 of debt financing for every $1 in equity financing.

The D/E ratio measures financial risk or financial leverage. In general, a higher ratio means a higher risk, and a lower ratio means a lower risk. In this example, company A has a high debt-to-equity ratio. This might signify that the company is in financial distress and cannot fulfill its debt obligations. In addition, it most likely will be a very risky investment. On the other hand, company B, with a ratio of around 1, which is considered ideal in many cases, will be a less risky investment.

Besides being a financial leverage ratio, the debt-to-equity ratio is also a gearing ratio.  A gearing ratio is a financial ratio category that compares company debt to financial metrics such as total equity or assets.

To calculate the debt/equity ratio, you need a company’s total liabilities and total shareholders’ equity, both of which you can find on the company’s balance sheet. A balance sheet presents a company’s financial position by balancing a company’s total assets with a company’s total liabilities and total equity at a specific point in time.

Assets = Liabilities + Shareholder Equity​

Cost of Equity versus Cost of Debt

An Infographic that shows the differences between debt and equity financing. Debt has to be paid back with interest, provides no ownership, has a fixed cost, lenders do not share in profits and if the company goes bankrupt, lenders get paid first. Equity shareholders are part-owners who get dividend payments and voting rights, the cost of equity is not fixed, and when the company goes bankrupt, shareholders get paid last.

Every company requires funds to function, and many companies can meet their revenue expenditure through their daily operations. However, capital expenditure often requires external funding, and typically, there are two ways to generate funds externally. Either through equity or debt. Investors use the debt-to-equity ratio to see how much debt a company has compared to the amount invested by its owners.

Generally, investors tend to favor companies with a low debt-to-equity ratio because a low ratio implies lower risk. Fundamentally this is correct because a low or manageable debt-to-equity ratio means that the company only has to use a small portion of its earnings to repay its debts. This means that more earnings will be available to the shareholders of the company.

However, debt is not an inherently bad thing for a company to have on the balance sheet. On the contrary, it gives a company more flexibility in its capital funding. The difficult question is how much debt is the right amount of debt and how much debt is too much?

Equity may look like the best option to generate funds for capital projects as there is a general notion that equity is cheaper than debt. In addition, it does not carry interest costs and does not need to be repaid. However, the notion that equity is free is, of course, not correct. There are costs associated with equity as well.

Cost of Equity

Equity is the ownership of assets. The cost of equity means different things depending on who you are. 

If you are the investor, the cost of equity is the required rate of return on equity. Before investing, you set goals. Therefore, you will only decide to buy a company’s shares if you believe that the expected return on equity meets your goals. 

If you are the company that is issuing the shares, the cost of equity determines the required rate of return on a particular project or investment. 

Cost of Debt

Debt is the amount of money borrowed by one party from another and needs to be paid back later. The cost of debt is the interest that has to be paid on the outstanding amount until the debt has been paid back in full. 

Typically, debt is financed at an interest cost far below an investor’s cost of equity. In addition, the interest a company pays on its interest-bearing debt is tax-deductible.

So, what is the right balance between a company’s debt and its equity? In other words, what is a good debt-to-equity ratio for a company?

What Is a Good Debt-To-Equity Ratio?

An extremely high debt-to-equity ratio is not a good sign for a company. It means that a company is highly leveraged, and debt needs to be paid back with interest. High debt often results in higher interest rates, increasing risk, and will most likely decrease the stock price. It can also limit access to new loans in case of emergency needs.

A very low debt-to-equity ratio is usually not a good sign either. It could mean that a company has too much cash on hand and is too conservative. By not reinvesting enough into the company, it is missing out on future growth opportunities.

So what is considered a good D/E ratio? Unfortunately, there is no exact number that answers that question for every company. In general, a good debt-to-equity ratio is around 1 to 1.5. However, the ideal debt-to-equity ratio will vary depending on the industry. For example, some industries use more debt financing than others. In that case, a higher ratio might be ok. An ideal D/E ratio also depends on how well the company uses the money it has borrowed. 

Increasing debt to use for capital-intensive process improvements or new, more efficient equipment can increase a company’s earnings significantly. If the debt increases earnings by a larger amount than the debt’s interest cost, shareholders benefit as the equity has not increased. However, if the interest cost is higher than the increased earnings, the stock’s market value and the company will decline.

Interpreting the Debt-To-Equity Ratio

When it comes to interpreting the debt-to-equity ratio, the standard protocol is the same as other ratios. Financial ratios can be analyzed in several ways, depending on the circumstances. 

Investors can compare the company’s current debt-to-equity ratio with the debt/equity ratio of previous years to see how the company has managed its debt structure over time. A gradually rising debt-to-equity ratio means that the company is becoming riskier. However, it can also mean that it is increasing capital expenditure for future growth. Therefore, investors will also need to look at the capital expenditure and profitability of the company to see whether the company’s profitability has increased over time or not. If a rising debt-to-equity ratio is complemented by rising profitability, then there is less of a concern. 

On the other hand, a falling debt-to-equity ratio may suggest that the company has undertaken debt restructuring to meet industry or financial regulatory requirements. For example, banks and regulatory authorities may require firms to maintain their debt-to-equity ratio under a certain limit to access more funds or issue shares.

Another thing to consider is the type of industry a company is in, as different industries have different capital needs. Therefore, different industries have different “acceptable” D/E ratios. Thus, a high ratio may be common in one industry, while a low D/E may be common in another. For example, an industry like auto manufacturing that is very capital-intensive will have a higher debt-to-equity ratio than a consulting company that is not as capital-intensive and has lower debt. 

Capital-intensive industries typically have a debt/equity ratio above 2, while tech or services firms typically have a debt/equity ratio under 0.5. Therefore, it is always advised to compare the D/E ratio of a company with similar companies in the same industry. This comparison can help investors analyze whether their target company is leveraged higher or lower than the industry. Industry ratios can also be used for benchmarking by management to see how their company stacks up against its competitors. 

How to Use the Debt-To-Equity Ratio?

As mentioned earlier, the debt-to-equity ratio is used by different stakeholders to assess the company’s financial health. For example, banks and financial regulators use the ratio to see how much debt the business is exposed to before allowing access to more business loans and funds.

Investors use this ratio to determine the level of risk that the company has taken on. Typically, a high debt-to-equity ratio is generally understood as a bad sign. It means that the company is taking on a high amount of debt that it will need to repay in the future. This doesn’t necessarily mean that the company is in danger, as long as other indicators, such as profitability and liquidity, are good.

Company CFOs and financial managers have to pay close attention to this ratio because they are responsible for managing the debt-to-equity ratio and keeping it within acceptable limits.

The usage of the ratio, therefore, depends on the objective of the stakeholder. Furthermore, as previously discussed, the D/E ratio is not as easy to understand as it appears. Therefore, stakeholders should not look at it in a vacuum but consider many other factors when evaluating this ratio.

Modifications to the Debt-To-Equity Ratio

When looking at a balance sheet, total liabilities and shareholders’ equity are divided into many subcategories. Some of those subcategories would normally not be considered “debt” or “equity” in the traditional sense of a loan book value of an asset.

Line items such as retained earnings and intangible assets are often not really thought of as a liability or equity. However, because the D/E value is affected by these subcategories, stakeholders such as investors and analysts will often modify the D/E ratio. They do this by excluding some of these ambiguous line items. They do this to make the debt/equity ratio fit their needs, make the ratio look more favorable, or make the ratio easier to compare between different stocks.

The debt-to-equity ratio can be modified to give a more specific look into a company’s capital structure. For instance, an analyst may want to exclude the short-term debt from the formula to focus only on the risk of long-term debt of the company. Analysts may go for this approach because if the company’s liquidity is good, then short-term debts do not matter that much as they will be paid off within a year.

In addition, short-term debts are less exposed to interest rate changes as compared to long-term debts. Therefore, stakeholders are more focused on the long-term debt, so they modify the debt-to-equity ratio into the long-term debt-to-equity ratio.  

Similarly, there is a debate about whether to include preferred stocks in shareholders’ equity or not. As a result, in the Earnings per Share (EPS) ratio, preferred stock is excluded from the calculations.

Dependent on the objective of the stakeholder, the debt-to-equity formula may be modified to exclude preferred stock from equity and include it in a company’s debt instead. The move from equity to debt makes sense because preferred stock comes with a guaranteed dividend payment and liquidation rights, and therefore, is seen more like debt. This can result in a D/E ratio that will be significantly higher than the non-modified D/E ratio, in which the preferred stock is part of equity.

Limitations of the Debt-To-Equity Ratio 

  • Industry Specific: Healthy ratios vary by industry. A relatively high D/E ratio may be common in one industry but not in another. Therefore it is not a good idea to compare D/E ratios for companies in different industries and sectors.
  • Share buybacks: Companies may buy back their shares while undergoing capital restructuring. A share buyback reduces the amount of equity thereby making the debt-to-equity ratio appear higher, and an investment riskier. However, in reality the fundamentals of the company are still the same. The effect of reduced equity pushes the ratio higher and therefore investors need to be aware of the capital restructuring history of a company while looking at the ratio.
  • Modified D/E ratios: Dependent on who publishes the D/E ratio and for what purpose , it is possible that the D/E ratio is a modified version.Therefore, it is crudial to find out what exactly is included in the “liabilities” and “equity” used in the ratio.
  • Only part of the financial analysis: The debt-to-equity ratio should not be the only ratio to consider. Investors need to do an in-depth fundamental analysis of a company to assess a company’s financial health. 

Conclusion

The debt-to-equity ratio is a key ratio when it comes to determining the leverage of a company. The ratio implies the level of risk a company has. So, therefore, it helps investors and lenders decide whether to invest in the company or not. 

Although the ratio looks pretty simple and the basic version is easy to understand, analysis of it has layers of complexity that need to be analyzed to gain a comprehensive understanding of the information being communicated. Furthermore, it is important never to look at the ratio in a vacuum and always to examine it within the broader context of a company’s overall financial picture.

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.