What Is Debt To Equity Ratio (D/E)? | Important Metrics Smart Value Need To Know
Debt-to-Equity Ratio (D/E) is the metric that helps 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 high leverage, and a lower number will mean the company is less leveraged.
Another name for the debt-to-equity ratio is the risk ratio, or leverage ratio (“Gearing Ratio” for REITs).
Numbers to be considered in the 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 financial indicator used for fundamental analysis, a relatively good measurement of the risk the company is taking to continue operation.
How To Calculate Debt To Equity Ratio?
The formula for the 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
or
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?
The debt-to-equity ratio tells you how much debt you have 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 industries.
Some industry such as the automobile depends heavily on debt, while the energy industry usually has a lower level of debt.
What does a Debt-To-Equity Ratio of 0.5 mean?
A debt to equity ratio of 0.5 means the company uses twice as much equity to drive the growth of the company than it uses debt aka. “borrowed money”. The shareholders/ investors, therefore, own two-thirds of the company’s assets. With a 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 equity to drive the growth of the company as it uses debt aka. “borrowed money”. The shareholders/ investors, therefore, own half of the company’s assets. With a D/E of 1.0, many companies lie 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 debt aka. “borrowed money” to drive the growth of the company as it uses equity. The shareholders/ investors, therefore, own a quarter of the company’s assets. With a 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?
General consensus is that D/E should not be above the level of 2.0. While some industries which require a high level of fixed assets such as; mining, manufacturing, and transportation may have higher than 2.0. These are exceptions. Most companies will have a D/E ratio of less than 1.5.
A good debt-to-equity ratio varies between industries.
Generally speaking, you will want a low D/E when compared with the other companies in the industry of those which are of a similar sector.
Average Debt to Equity Ratio By Industry
| Ranking | Sector | D/E Ratio |
|---|---|---|
| 1 | Energy | 0.46 |
| 2 | Capital Goods | 0.58 |
| 3 | Healthcare | 0.69 |
| 4 | Consumer Discretionary | 0.75 |
| 5 | Technology | 0.8 |
| 6 | Basic Materials | 0.83 |
| 7 | Services | 1.04 |
| 8 | Consumer Non-Cyclical | 1.09 |
| 9 | Retail | 1.09 |
| 10 | Conglomerates | 1.17 |
| 11 | Utilities | 1.27 |
| 12 | Financial | 1.29 |
| 13 | Transportation | 2.79 |
Source: csimarket
A quick look at the data gives us some interesting insight into the performance of different sectors:
- The industry-standard debt-to-equity ratio is 1.0.
- The industry with the lowest debt-to-equity ratio is Energy.
- The industry with the 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 does a proper fundamental analysis of the company, she can understand more about the financial health of the company.
The Debt-To-Equity Ratio is just one of the many fundamental analysis numbers that Susan needs to calculate. This number allows her to have a rough idea of how “risky” it will be to invest in ABC company.
The company has provided the following information on the website:
| Financial Data | $ |
|---|---|
| Short Terms Debt | $500 |
| Long Term Debt | $1,000 |
| Fixed Payment Obligations | $500 |
| Shareholders’ Equity | $1,000 |
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
Debt to equity ratio is a financial ratio that compares a company’s total liabilities to its total shareholder equity. But like all financial metrics, the D/E ratio has its own very set of advantages and disadvantages.
Advantage of debt-to-equity ratio
- Measures Profitability: The 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 ways to measure the level of risk for investing in a company. Higher D/E will generally imply higher risk. A lower D/E ratio will generally indicate a lower risk. By understanding the D/E ratio, the investor can decide if investing in the company fit within their risk tolerance level.
Tip: Use the Debt-To-Equity Ratio to compare companies that have similar sizes and industries.
Disadvantages of debt-to-equity ratio
- Sector/ Industry Dependent: The debt-to-equity ratio is very industry specific. Industries that 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 Debt-To-Equity Ratio Is 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 that 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 the P/B Ratio to find undervalued stocks.
Other ratios, such as Quick Ratio, Current Ratio, or Cash Ratio are usually used concurrently 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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Antony C. is a dividend investor with over 15+ years of investing experience. He’s also the book author of “Start Small, Dream Big“, certified PMP® holder and founder of IncomeBuddies.com (IB). At IB, he share his personal journey and expertise on growing passive income through dividend investing and building online business. Antony has been featured in global news outlet including Yahoo Finance, Nasdaq and Non Fiction Author Association (NFAA).
