Debt-to-Equity Ratio (D/E) is the metric help us visualize how capital has been raised to finance the operation of the company. D/E Ratio is generally used to evaluate a company’s financial health. A higher number will mean the company is highly leverage, and a lower number will mean the company is less leveraged.
Another name for debt-to-equity ratio is risk ratio, or leverage ratio (“Gearing Ratio” for REITs).
Numbers to be considered in Debt-to-Equity Ratio are:
- Short Term Debt
- Long Term Debt
- Fixed Payment Obligations
- Total Liabilities
- Total Shareholders’ Equities
Debt-to-Equity Ratio is a relatively good measurement on the risk the company is taking to continue operation.
How to calculate debt to equity ratio?
The formula for Debt to Equity Ratio is calculated by dividing the total shareholders’ equity by the total liabilities.
Debt to Equity Ratio = Total Liabilities/ Total Shareholders’ Equities
Debt to Equity Ratio = (Short term debt + Long term debt + Fixed payment obligations) / Shareholders’ Equity
You can generally get these numbers from the balance sheet found in the annual financial report provided by the company.
How to interpret debt to equity ratio?
Debt to equity ratio tells you how much debt you have in compared to your equity. A ratio of less than 1.0 means that you have less debt than equity. A ratio of more than 1.0 means that you have more debt than equity.
Interpretation of the Debt-To-Equity ratio can vary between industry.
Some industry such as the automobile depends heavily on debt, while energy industry usually have lower level of debt.
What does a Debt-To-Equity Ratio of 0.5 mean?
Debt to equity ratio of 0.5 means the company uses twice as much of equity to drive growth of the company than it uses debt aka. “borrowed money”. The shareholders/ investors, therefore, own two-thirds of the company’s assets. With D/E of 0.5 or less, the company is generally able to survive any unforeseen black swan events.
What does a Debt-To-Equity Ratio of 1.0 mean?
Debt to equity ratio of 1.0 means the company uses just as much of equity to drive growth of the company as it uses debt aka. “borrowed money”. The shareholders/ investors, therefore, own half of the company’s assets. With D/E of 1.0, most company lies in this range.
What does a Debt-To-Equity Ratio of 1.5 mean?
Debt to equity ratio of 1.5 the company uses just thrice as much of debt aka. “borrowed money” to drive growth of the company as it uses equity. The shareholders/ investors, therefore, own a quarter of the company’s assets. With D/E of 1.5, the company is using a high level of debt to drive growth.
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What is a Good Debt-To-Equity Ratio?
A good debt-to-equity ratio vary between industry. But the general consensus is that, D/E should not be above the level of 2.0. While some industries which requires high level of fixed-assets such as; mining, manufacturing and transportation may have higher than 2.0. These are exception. Most companies will have a D/E ratio of less than 1.5.
General speaking, you will want a low D/E when compared with the other companies in the industry of those which are of the similar sector.
Average Debt to Equity Ratio by Industry
|8||Consumer Non Cyclical||1.09|
A quick look at the data give us some interesting insight on the performance of different sectors:
- Industry standard debt to equity ratio is 1.0.
- Industry with lowest debt to equity ratio is Energy.
- Industry with highest debt to equity ratio is Transportation.
example of debt to equity ratio calculation
Let’s use an example to understand the calculation of the Debt to Equity Ratio formula better.
Susan is a smart low-risk dividend investor who is thinking of investing at ABC Company.
Susan knows that if she do a proper fundamental analysis of the company, she can understand more about the financial health of the company.
Debt-To-Equity Ratio is just one of the many fundamental analysis numbers that Susan need to calculate. This number allows her to have a rough idea on how “risky” it will be to invest into ABC company.
The company has provided the following information in the website:
|Short Terms Debt||$500|
|Long Term Debt||$1,000|
|Fixed Payment Obligations||$500|
What is the Debt to Equity Ratio of the Company?
Debt-to-Equity Ratio is calculated by using the formula given below:
Debt-to-Equity Ratio = (Short term debt + Long term debt + Fixed payment obligations) / Shareholders’ Equity
Debt-to-Equity Ratio = ($500 + $1,000 + $500) / $1,000
Debt-to-Equity Ratio = 2.0
The calculated debt-to-equity ratio of the company is 2.0. The calculated D/E Ratio is more than 1.5 which is high for a low-risk investor like Susan.
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advantage and disadvantage of debt to equity ratio
advantage of debt to equity ratio
- Measures Profitability: Debt to Equity Ratio help to give an indication of how much profit will be available for the shareholders.
- Measures Risk: This ratio is one of the best way to measure the level of risk for investing at a company. Higher D/E will generally implies a higher risk. A lower D/E ration will generally indicate a lower risk. By understanding D/E ratio, the investor can decide if investing in the company fit within their risk tolerance level.
Tip: Use Debt-To-Equity Ratio to compare companies that have similar size and industry.
disadvantages of debt to equity ratio
- Sector/ Industry Dependent: Debt-To-Equity Ratio is very industry specific. Industries which require a larger investment in fixed assets will generally have a higher D/E ratio. Therefore the ratio can only be used to compare within the same industry.
why is debt to equity ratio important to investors
Debt to Equity Ratio is considered one of the most important financial metrics because it helps to measure the financial health and stability of a company.
Debt to Equity Ratio is the preferred way by most investors to determine how risky it is to invest in a company by looking at the leverage ratio of the company.
Debt to Equity Ratio is especially important in unpredictable times. D/E can help you in finding companies which can survive through unpredictable black swan events such as pandemic.
While you can also look into other financial metrics to find stocks that give a margin of safety, such as P/B Ratio to find undervalued stocks.
Other ratios, such as Quick Ratio, Current Ratio or Cash Ratio are usually used in concurrent with Debt to Equity Ratio to help investors to assess the risk level when investing in a company.
“I’ve seen more people fail because of liquor and leverage, leverage being borrowed money.
You really don’t need leverage in this world much.
If you’re smart, you’re going to make a lot of money without borrowing.”
– Warren Buffett
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