What Is The Debt-To-Equity Ratio?

The debt to equity ratio is a financial metric used to gauge a company’s leverage. The debt-to-equity ratio demonstrates to investors how heavily a company relies on debt financing, as opposed to its own assets, in order to grow.

How To Calculate The Debt-To-Equity Ratio

Investors looking to analyze a company’s leverage can gather facts from its balance sheet and calculate the debt-to-equity ratio using the formula below.

Debt-To-Equity = Total Liabilities / Total Shareholders’ Equity

How To Analyze The Debt-To-Equity Ratio

As stated before, the debt-to-equity helps investors gauge the extent of leverage a company relies on. Highly leverage companies often take on greater risk of bankruptcy. Highly leveraged companies will have high debt-to-equity ratios as they rely heavily on debt financing in order to grow. So, what is considered a high debt-to-equity ratio? The answer may not be so straight forward.

Analyzing The Ratio On a Case-To-Case Basis

As with most financial metrics, the debt-to-equity ratio results vary greatly across industries. Different industries require very different capital structures and intensities. However, two companies which operate very similarly may be compared via the debt-to-equity ratio; the company with the higher ratio is relying on riskier forms of financing its future growth.

Is a High Debt-To-Equity Ratio a Deal Breaker?

So, if a company has a high debt-to-equity ratio compared to similar companies should you automatically rule it out? Probably not. Understanding a company’s leverage situation requires more in-depth analysis. For example, some companies are more comfortable taking on leverage if they have high levels of stable recurring revenue sources. Also, debt may be beneficial to companies, when used appropriately. In other words, the debt-to-equity ratio should be examined on a case-to-case basis.

Down Sides To The Ratio

Unfortunately, the debt-to-equity ratio is not a perfect metric. As mentioned before, the debt-to-equity ratio is not comparable across industries. Another limitation to this ratio is that it implies that all debt is the same. Without accounting for things like future plans and potential growth rates, investors will automatically ignore the potential benefits associated with taking on debt. Another limitation with the debt-to-equity ratio is the lack of attention paid to short-term leverage, an aspect which is very important when evaluating a company’s fiscal health.

Alternative Ways To Evaluate Leverage

While the debt-to-equity ratio is a good start, there are alternatives that may be more beneficial when evaluating specific situations. For example, when evaluating short-term leverage, liquidity ratios, such as the current or cash ratio, may be more beneficial than the debt-to-equity ratio.

Example Of The Debt-To-Equity Ratio

Let’s say XYZ Auto has $100,000 in total liabilities on its balance sheet. XYZ Auto also has $50,000 in shareholders’ equity on its balance sheet. This means XYZ Auto has a debt-to-equity ratio of 2:1, in other words for every $1 in equity XYZ has, it also has $2 in debt. Assuming the average debt-to-equity ration in the automobile industry is 1, it can be assumed that XYZ Auto is relying on an abnormal amount of leverage to finance its growth. This indicates to investors that XYZ Auto is taking on risk but a decision on investment should rely on additional factors.

Debt-To-Equity Ratio