What Is Debt-to-Equity (D/E) Ratio?
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 shareholder equity. D/E ratio is an important metric in corporate finance. It is a measure of the degree to which a company is financing its operations with debt rather than its own resources. The debt-to-equity ratio is a particular type of gearing ratio.
The information needed to calculate D/E ratio can be found on a listed company’s balance sheet. Subtracting the value of liabilities on the balance sheet from that of total assets shown there provides the figure for shareholder equity, which is a rearranged version of this balance sheet equation:
These balance sheet categories may include items that would not normally be considered debt or equity in the traditional sense of a loan or an asset. Because the ratio can be distorted by retained earnings or losses, intangible assets, and pension plan adjustments, further research is usually needed to understand to what extent a company relies on debt.
To get a clearer picture and facilitate comparisons, analysts and investors will often modify the D/E ratio. They also assess the D/E ratio in the context of short-term leverage ratios, profitability, and growth expectations.
How to Calculate D/E Ratio in Excel?
Business owners use a variety of software to track D/E ratios and other financial metrics. Microsoft Excel provides a balance sheet template that automatically calculates financial ratios such as D/E ratio and debt ratio.
Or you could enter the values for total liabilities and shareholders’ equity in adjacent spreadsheet cells, say B2 and B3, then add the formula “=B2/B3” in cell B4 to obtain the D/E ratio.
What Does D/E Ratio Tell You?
D/E ratio measures how much debt a company has taken on relative to the value of its assets net of liabilities. Debt must be repaid or refinanced, imposes interest expense that typically can’t be deferred, and could impair or destroy the value of equity in the event of a default. As a result, a high D/E ratio is often associated with high investment risk; it means that a company relies primarily on debt financing.
Debt-financed growth may serve to increase earnings, and if the incremental profit increase exceeds the related rise in debt service costs, then shareholders should expect to benefit. However, if the additional cost of debt financing outweighs the additional income that it generates, then the share price may drop. The cost of debt and a company’s ability to service it can vary with market conditions. As a result, borrowing that seemed prudent at first can prove unprofitable later under different circumstances.
Changes in long-term debt and assets tend to affect D/E ratio the most because the numbers involved tend to be larger than for short-term debt and short-term assets. If investors want to evaluate a company’s short-term leverage and its ability to meet debt obligations that must be paid over a year or less, they can use other ratios.
Example of D/E Ratio
Let’s consider a historical example from Apple Inc. (AAPL). We can see below that for the fiscal year (FY) ended 2017, Apple had total liabilities of $241 billion (rounded) and total shareholders’ equity of $134 billion, according to the company’s 10-K statement.
The result means that Apple had $1.80 of debt for every dollar of equity. But on its own, the ratio doesn’t give investors the complete picture. It’s important to compare the ratio with that of other similar companies.
Modifying the D/E Ratio
Not all debt is equally risky. The long-term D/E ratio focuses on riskier long-term debt by using its value instead of that of total liabilities in the numerator of the standard formula:
Long-term D/E ratio = Long-term debt ÷ Shareholder equity
Short-term debt also increases a company’s leverage, of course, but because these liabilities must be paid in a year or less, they aren’t as risky. For example, imagine a company with $1 million in short-term payables (wages, accounts payable, notes, etc.) and $500,000 in long-term debt, compared with a company with $500,000 in short-term payables and $1 million in long-term debt. If both companies have $1.5 million in shareholder equity, then they both have a D/E ratio of 1. On the surface, the risk from leverage is identical, but in reality, the second company is riskier.
As a rule, short-term debt tends to be cheaper than long-term debt and is less sensitive to shifts in interest rates, meaning that the second company’s interest expense and cost of capital are likely higher. If interest rates are higher when the long-term debt comes due and needs to be refinanced, then interest expense will rise.
Finally, if we assume that the company will not default over the next year, then debt due sooner shouldn’t be a concern. In contrast, a company’s ability to service long-term debt will depend on its long-term business prospects, which are less certain.
D/E Ratio for Personal Finances
D/E ratio can apply to personal financial statements as well, serving as a personal D/E ratio. Here, equity refers to the difference between the total value of an individual’s assets and their aggregate debt, or liabilities.
The personal D/E ratio is often used when an individual or a small business is applying for a loan. Lenders use the D/E figure to assess a loan applicant’s ability to continue making loan payments in the event of a temporary loss of income.
For example, a prospective mortgage borrower is more likely to be able to continue making payments during a period of extended unemployment if they have more assets than debt. This is also true for an individual applying for a small business loan or a line of credit. If the business owner has a good personal D/E ratio, it is more likely that they can continue making loan payments until their debt-financed investment starts paying off.
D/E Ratio vs. Gearing Ratio
Gearing ratios constitute a broad category of financial ratios, of which the D/E ratio is the best known. “Gearing” is a term for financial leverage.
Gearing ratios focus more heavily on the concept of leverage than other ratios used in accounting or investment analysis. The underlying principle generally assumes that some leverage is good, but that too much places an organization at risk.
Limitations of D/E Ratio
When using D/E ratio, it is very important to consider the industry in which the company operates. Because different industries have different capital needs and growth rates, a D/E ratio value that’s common in one industry might be a red flag in another.
Utility stocks often have especially high D/E ratios. As a highly regulated industry making large investments typically at a stable rate of return and generating a steady income stream, utilities borrow heavily and relatively cheaply. High leverage ratios in slow-growth industries with stable income represent an efficient use of capital. Companies in the consumer staples sector tend to have high D/E ratios for similar reasons.
Analysts are not always consistent about what is defined as debt. For example, preferred stock is sometimes considered equity, since preferred dividend payments are not legal obligations, and preferred shares rank below all debt (but above common stock) in the priority of their claim on corporate assets. On the other hand, the typically steady preferred dividend, par value, and liquidation rights make preferred shares look more like debt.
Including preferred stock in total debt will increase the D/E ratio and make a company look riskier. Including preferred stock in the equity portion of the D/E ratio will increase the denominator and lower the ratio. This is a particularly thorny issue in analyzing industries notably reliant on preferred stock financing, such as real estate investment trusts (REITs).
What is a good debt-to-equity (D/E) ratio?
What counts as 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 would be seen as relatively safe, whereas values of 2 or higher might be considered risky. Companies in some industries, such as utilities, consumer staples, and banking, typically have relatively high D/E ratios. Note that a particularly low D/E ratio may be negative, suggesting that the company is not taking advantage of debt financing and its tax advantages. (Business interest expense is usually tax deductible, while dividend payments are subject to corporate and personal income tax.)
What does a D/E ratio of 1.5 indicate?
A D/E 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 does a negative D/E ratio signal?
If a company has a negative D/E ratio, this means that it has negative shareholder equity. In other words, the company’s liabilities exceed its assets. In most cases, this would be considered a sign of high risk and an incentive to seek bankruptcy protection.
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 in the form of branch networks. Higher D/E ratios can also tend to predominate in other capital-intensive sectors heavily reliant on debt financings, such as airlines and industrials.
How can D/E ratio be used to measure a company’s riskiness?
A steadily rising D/E ratio may make it harder for a company to obtain financing in the future. The growing reliance on debt could eventually lead to difficulties in servicing the company’s current loan obligations. Very high D/E ratios may eventually result in loan default or bankruptcy.