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Debt-To-Equity Ratio: Explanation, Formula, Example Calculations


The debt-to-equity (D/E) ratio is used to evaluate a company’s financial leverage and is calculated by dividing a company’s total liabilities by its equity.

Debt-To-Equity Ratio Explanation, Formula, Example Calculations

There are several metrics that are used to gauge the financial health of a company, how the company finances its business operations and assets, as well as its level of exposure to risk. One of these metrics is debt to equity ratio.

In this article, we are going to look at how debt to equity ratio is calculated and how to interpret it, the difference between debt to equity ratio and financial leverage, as well as the limitations of debt to equity ratio. 

Before that, however, let’s take a moment to understand what exactly debt to equity ratio means.

What Is The Debt To Equity Ratio?

Debt to equity ratio is a metric that looks at a company’s total financial liabilities in comparison to shareholder equity. This metric tells whether a company is financing its operations through its own funds, or through debt, and the degree to which it is doing so.

Debt to equity ratio also measures the ability of a company to cover all its financial obligations to creditors using shareholder equity in case of a decline in business.

Debt to equity ratio can easily be confused with debt to asset ratio. The difference, however, is that whereas debt to asset ratio compares a company’s debt to its total assets, debt to equity ratio compares a company’s liabilities to equity (assets less liabilities).

How To Calculate Debt To Equity Ratio

Debt to Equity Ratio Formula
Source: EDUCBA

The simple formula for calculating debt to equity ratio is to divide a company’s total liabilities by its total equity.

A company’s total liabilities are the aggregate of all its financial obligations to creditors over a specific period of time, and typically include short term and long term liabilities and other liabilities.

Short term liabilities are financial obligations that are due in a year or less, and include accrued expenses that the company is yet to receive an invoice for, accounts payable, unearned revenue, short-term notes payable, payroll expenses, dividends payable, deposits, and advances.

Long term liabilities are financial obligations with a maturity of more than a year. They include long-term notes payable, lines of credit, bonds, deferred tax liabilities, loans, debentures, pension obligations, and so on.

Total equity, on the other hand, refers to the total amount that investors have invested into the company, plus all its earnings, less it’s liabilities.

Therefore, the long formula for calculating debt to equity ratio would be:

Debt to equity ratio = (Long term liabilities + short term liabilities + other liabilities)

                                                             (assets + earnings – total liabilities)

How To Interpret The Debt To Equity Ratio

A company’s debt to equity ratio provides investors with an easy way to gauge the company’s financial health and its capital infrastructure.

A high debt to equity ratio means that a company is highly dependent on debt to finance its growth. A high debt to equity ratio is not entirely a bad thing.

If a company is using debt to finance its growth, this can potentially provide higher return on investment for shareholders, since the company is generating profits from other people’s money. 

For this to happen, however, the cost of debt should be significantly less than the increase in earnings brought about by leverage.

A low debt to equity ratio, on the other hand, means that the company is highly dependent on shareholder investment to finance its growth.

While this limits the amount of liability the company is exposed to, low debt to equity ratio can also limit the company’s growth and expansion, because the company is not leveraging its assets.

1. Level Of Risk

A company’s debt to equity ratio can also be used to gauge the financial risk of the company. 

A high debt to equity ratio means that the company is highly leveraged, which in turn puts it at a higher risk of bankruptcy in the event of a decline in business or an economic downturn.

This is because the company will still need to meet its debt payment obligations, which are higher than the amount of equity invested into the company.

2. Shareholder Earnings

Debt to equity ratio also affects how much shareholders earn as part of profit. With low borrowing costs, a high debt to equity ratio can lead to increased dividends, since the company is generating more profits without any increase in shareholder investment.

With high borrowing costs, however, a high debt to equity ratio will lead to decreased dividends, since a large portion of profits will go towards servicing the debt.

Debt to Equity Ratio vs Financial Leverage

Very often, people confuse debt to equity ratio with financial leverage, and sometimes, it is even possible to hear people using both terms interchangeably. So, what’s the difference between the two?

Financial leverage simply refers to the use of external financing (debt) to acquire assets. With financial leverage, the expectation is that the acquired asset will generate enough income or capital gain to offset the cost of borrowing.

Financial leverage allows businesses (or individuals) to amplify their return on investment. 

For instance, let’s assume that a company is interested in purchasing an asset at a cost of $100,000. The asset is expected to appreciate in value by 30% annually.

If the company uses its own money to purchase the asset, which they then sell a year later after 30% appreciation, the company will have made $30,000 in profit (130% x $100,000 – $100,000). Their return on investment will also be 30% ($30,000 / $100,000 x 100%).

If the company acquires the same asset using $50,000 of its own money and $50,000 in borrowed money, then they sell it a year later after 30% appreciation, they’ll still have made $30,000 in profit (130% x $100,000 – $50,000 (debt) – $50,000).

However, because the company only spent $50,000 of their own money, the return on investment will be 60% ($30,000 / $50,000 x 100%).

Debt to equity ratio is the most commonly used ratio for measuring financial leverage. However, it is not the only one. Other ratios used for measuring financial leverage include interest coverage ratio, debt to assets ratio, debt to EBITDA ratio, and debt to capital ratio.

Limitations Of The Debt To Equity Ratio

Despite being a good measure of a company’s financial health, debt to equity ratio has some limitations that affect its effectiveness. Below are some of these limitations.

1. It Can Misguide Investors

In most cases, a low debt to equity ratio signifies a company with a significantly low risk of bankruptcy, which is a good sign to investors.

Sometimes, however, a low debt to equity ratio could be caused by a company’s inability to leverage its assets and use debt to finance more growth, which translates to lower return on investment for shareholders.

In addition, debt to equity ratio can be misleading due to different accounting practices between different companies. 

For instance, if a company includes preferring stock in debt, this can result in a high debt to equity ratio that could appear risky to investors, when in actual sense, the company is not operating on borrowed funds.

2. It Is Not Effective For Comparing Companies From Different Industries

If you are considering investing in two companies from different industries, the debt to equity ratio does not provide an effective way to compare the two companies and determine which is the better investment.

This is because ideal debt to equity ratios will vary from one industry to another. For instance, in capital intensive industries like manufacturing, debt financing is almost always necessary to help a business grow and generate more profits. In such industries, a high debt to equity ratio is not a cause for concern.

In other industries, such as IT, which don’t require much capital, a high debt to equity ratio is a sign of great risk, and therefore, a much lower debt to equity ratio is more preferable.

For someone comparing companies in these two industries, it would be impossible to tell which company makes better investment sense by simply looking at both of their debt to equity ratios.

Example Calculations Of Debt To Equity Ratio

Calculation of Debt To Equity Ratio: Example 1

Company A has $2 million invested in the company by its investors. The company also has a $500,000 mortgage, a $300,000 loan, and $200,000 in unearned revenue. What is the debt to equity ratio for company A?

Since debt to equity ratio is calculated by dividing total liabilities by shareholder equity, the D/E ratio for company A will be:

$200,000 + $300,000 + $500,000 = 0.5

$2,000,000

This means that for every $1 invested into the company by investors, lenders provide $0.5.

Calculation of Debt To Equity Ratio: Example 2

Company B has $100,000 in debentures, long term liabilities worth $500,000 and $50,000 in short term liabilities. At the same time, the company has $250,000 in shareholder equity, $60,000 in reserves and surplus, and $10,000 in fictitious assets.

In such a scenario, the debt to equity ratio of company B will be:

($100,000 + $500,000 + $50,000) = 2.17

($250,000 + $60,000 – $10,000)

Such a high debt to equity ratio shows that the majority of this company’s assets and business operations are financed using borrowed money. In case of a negative shift in business, this company would face a high risk of bankruptcy.

Calculation of Debt To Equity Ratio: Example 3

Company C has the following information in their books:

  • Common Stocks – 200,000 shares at $5 each
  • Preferred stocks – $250,000
  • Current liabilities – $100,000
  • Non-current liabilities – $150,000

To determine the debt to equity ratio for Company C, we have to calculate the total liabilities and total equity, and then divide the two.

Total liabilities ($100,000 + $150,000) = 0.2

Total equity (200,000 x $5 + $250,000)

A debt ratio of 0.2 shows that it is very unlikely for Company C to become bankrupt, even if the economy were to crush. 

However, such a low debt to equity ratio also shows that Company C is not taking advantage of the benefits of financial leverage.

Debt To Equity Ratio FAQ

What Is A Good Debt To Equity Ratio?

There is no standard debt to equity ratio that is considered to be good for all companies. This is because a debt to equity ratio that is considered to be healthy in one industry could be seen as highly risky in another industry.

The thing to keep in mind is that generally, the higher the debt to equity ratio, the more likely a company is to go bankrupt in case of an economic downturn.

With this in mind, debt to equity ratios of about 1.0 or below are generally considered to be healthy, while debt to equity ratios above 2.0 are considered to be highly risky.

What Industries Have A High D/E Ratios?

High debt to equity ratios are commonplace among capital intensive industries such as banking and financial services, telecommunications, oil and gas, manufacturing, and the airline industry.

To produce their goods and services, these industries need large amounts of money, and therefore, it is common practice for these companies to turn to debt financing.

Another industry with high debt to equity ratios is the utilities industry. In addition to being highly capital intensive due to the need for massive infrastructure, utility companies generate stable amounts of income and are unlikely to have their income affected by economic conditions, making it easier for them to service their debt with minimal risk of exposure.

What Does A D/E Ratio Of 1.5 Mean?

If a company’s debt to equity ratio is 1.5, this means that for every $1 of equity, the company has $1.50 of debt. In other words, the company is funding 60% of its operations using debt.

What Does It Mean For D/E To Be Negative?

A negative debt to equity ratio means that the company’s assets are less than its liabilities

For instance, let’s say a company has S1 million in assets, and $1.5 million in liabilities. In this case, the debt to equity ratio of this company would be:

$1,500,000= -3

($1,000,000 – $1,500,000)

A negative debt to equity ratio is a sign that a company is very close to bankruptcy, which makes it very risky from an investment sense.

Is It Better To Have A High Or Low D/E Ratio?

Ideally, it is better to have a low debt to equity ratio. A low debt to equity ratio means a company is in a better position to meet its current financial obligations, even in the event of a decline in business. 

This in turn makes the company more attractive to investors and lenders, making it easier for the company to raise money when needed.However, a debt to equity ratio that is too low shows that the company is not taking advantage of debt, which means it is limiting its growth.

Written by
Martin Luenendonk
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