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Debt-to-Equity (D/E) Ratio

Debt-to-Equity (D/E) Ratio

When a company's operations or assets are funded principally by debt, it is often described as leveraged. To determine just the way that leveraged a company is, or to compare companies in terms of their respective reliance on debt, investors take a gander at leverage ratios, the most well known of which is the debt-to-equity ratio, or D/E ratio.

What Is a Debt-to-Equity (D/E) Ratio?

A debt-to-equity ratio is a metric โ€” expressed as either a percentage or a decimal โ€” that examines the extent of a company's operations that is funded by means of debt (otherwise called liabilities) versus shareholders' equity.
Assuming that a company's D/E ratio is 1.0 (or 100%), that means its liabilities are equal to its shareholders' equity. Anything higher than 1 indicates that a company relies more heavily on loans than equity to finance its operations. Anything short of 1, then again, indicates that a company relies more heavily on equity than debt.

How Do You Calculate a Company's D/E Ratio?

All to calculate a company's debt-to-equity ratio, divide its liabilities (including both short and long-term debts) by its total shareholders' equity.
Note: All of these figures can be found on a company's balance sheet.

D/E Ratio Formula

D/E = Total Liabilities/Shareholders' Equity

D/E Ratio Example: Bed Bath and Beyond (NASDAQ: BBBY)

As of November of 2021, Bed Bath and Beyond reported short-term debt of $348 million, long-term debt of $2,713 million, and shareholders' equity of $554 million.

D/E = Total Liabilities/Shareholders' Equity

D/E = ($348 million + $2,713 million)/$554 million

D/E = $3061 million/$554 million

D/E = 5.53

As of November 2021, BBBY's operations were financed by over five times as much debt than shareholders' equity.

What Does a Low D/E Ratio Mean?

The lower a company's D/E ratio, the less reliant its operations are on borrowed capital. This is often a good sign, as the less leveraged a company is, the less likely it is to default on payments, become insolvent, or fail.
When obviously a company will actually want to continue to pay off its debts, it becomes more attractive to investors for two reasons. To start with, it is unlikely to get into financial trouble that could cause its stock to lose huge value โ€” in other words, it's relatively "safe" โ€” and second, it will actually want to continue borrowing money to fund expansion and development projects that could make its stock more valuable over the long term.
Lenders might be more ready to offer capital to companies with low D/E ratios, and the loans they are offered may come with lower interest rates since their likelihood of default is relatively low.

What Does a High D/E Ratio Mean?

A high D/E ratio suggests that a company is genuinely reliant on borrowed capital for its continued operations. This isn't necessarily something bad, as basically all companies use debt to finance projects and growth.
For startups and newer companies undergoing expansion, specifically, a substantial amount of debt financing is completely normal. That being said, on the off chance that a more mature business that isn't developing rapidly has a D/E ratio a lot higher than its industry average, this could indicate that it is overly reliant on debt and could run into trouble in the event that its earnings slip.
Risk-averse investors who value stability over growth potential tend to avoid investing too heavily in companies that are altogether more leveraged than their industry peers. Lenders may likewise be hesitant to extend credit to highly leveraged firms, so the more debt a company has relative to its equity, the higher interest rates it is likely to have to pay on new debt.

What Is a Good D/E Ratio?

D/E ratios fluctuate altogether between industries and based on company age. Hence, there is no clear line between "high" and "low" ratios, and what is considered "good" can shift depending on who you ask. In general, on the off chance that a company's D/E ratio is noticeably lower than the average for their industry, company size, and company age, it very well may be safely considered good.

Average D/E Ratio by Industry

IndustryAverage D/E Ratio
Advertising0.50
Automotive0.20
Banks (Money Center)1.70
Farming/Agriculture0.37
Metals and Mining0.18
Oil/Gas Production/Exploration0.30
Real Estate Development0.77
Semiconductor 0.07
Tobacco0.26
Utilities (Not Water)0.69
Data as of January 2022 from NYU's Stern School of Business

Could a D/E Ratio Be Negative?

In the event that a business' D/E ratio is negative, this means that its shareholders' equity is negative because it has more liabilities than assets. This would indicate that a business might be headed for bankruptcy, and its stock would likely have little value.

What Are the Limitations of the D/E Ratio?

Because what is considered a "normal" D/E ratio varies such a lot of based on company age and industry, the metric isn't especially useful in looking at businesses that aren't especially comparable. Additionally, companies can purposefully lower their D/E ratios by giving preferred stock, which is listed under shareholders' equity despite behaving more like debt.

What Other Leverage Ratios Are There?

Debt to total assets is another famous leverage ratio. Instead of contrasting debt with equity, this metric compares debt to assets so investors can see the amount of what a company possesses was paid for with borrowed capital. To calculate a company's debt-to-total-assets ratio, divide its total liabilities by the total value of its assets. Anything above 0.5 (or half) indicates that the greater part of a company's assets were financed by debt.

Highlights

  • However, the D/E ratio is difficult to compare across industry bunches where ideal amounts of debt will change.
  • Higher-leverage ratios tend to indicate a company or stock with higher risk to shareholders.
  • Investors will often modify the D/E ratio to zero in on long-term debt simply because the risks associated with long-term liabilities are different than short-term debt and payables.
  • The debt-to-equity (D/E) ratio compares a company's total liabilities to its shareholder equity and can be used to evaluate how much leverage a company is utilizing.

FAQ

How Could the D/E Ratio Be Used to Measure a Company's Riskiness?

A higher D/E ratio might make it harder for a company to get financing from now on. This means that the firm might have a harder time servicing its existing debts. Very high D/Es can be indicative of a credit crisis in the future, including defaulting on loans or bonds, or even bankruptcy.

What Does a Debt-to-Equity (D/E) Ratio of 1.5 Indicate?

A debt-to-equity ratio of 1.5 would indicate that the company in question has $1.50 of debt for every $1 of equity. To illustrate, suppose the company had assets of $2 million and liabilities of $1.2 million. Because equity is equal to assets minus liabilities, the company's equity would be $800,000. Its D/E ratio would therefore be $1.2 million divided by $800,000, or 1.5.

What Is a Good Debt-to-Equity (D/E) Ratio?

What considers a "good" debt-to-equity (D/E) ratio will depend on the nature of the business and its industry. Generally speaking, a D/E ratio below 1.0 would be seen as relatively safe, whereas ratios of 2.0 or higher would be considered risky.Some industries, like banking, are known for having a lot higher D/E ratios than others. Note that a D/E ratio that is too low may really be a negative signal, indicating that the firm isn't exploiting debt financing to expand and develop.

What Industries Have High D/E Ratios?

In the banking and financial services sector, a relatively high D/E ratio is commonplace. Banks carry higher amounts of debt because they own substantial fixed assets as branch networks. Other industries that commonly show a relatively higher ratio are capital-intensive industries, for example, the airline industry or large manufacturing companies, which utilize a high level of debt financing as a common practice.

What's the significance here for D/E to Be Negative?

Assuming that a company has a negative D/E ratio, this means that the company has negative shareholder equity. In other words, it means that the company has more liabilities than assets. By and large, this is considered a very risky sign, indicating that the company might be at risk of bankruptcy. For instance, assuming the company in our earlier example had liabilities of $2.5 million, its D/E ratio would be - 5.