What is debt to equity ratio?
The debt to equity ratio, also known as risk ratio, is a calculation used to appraise a company’s financial leverage based on its shareholder equity. It measures how much a company is financing its activities through debt rather than owned cash, and whether a business would be able to cover its debts with shareholder equity if there was a sudden downturn or other financial shock.
This makes it different to the debt-assets ratio which uses a business’s total assets as a denominator, and instead highlights how a company’s finances are balanced between debt and equity financing.
Key takeaways from this section:
- The debt to equity ratio shows a company’s financial leverage by comparing its total liabilities to its shareholder equity.
- A high debt to equity ratio can show a higher risk to investors and shareholders.
- Debt to equity ratios can look very different across different industries and types of business, so aren’t always easy to compare
Understanding debt to equity ratio
A company’s debt to equity ratio broadly tells you how a company is using debt as a means of leveraging its assets. If a business has a high debt to equity ratio it can often be a sign of high risk, as it shows a company is aggressively borrowing in order to fuel growth or run its operations.
The potential risk it demonstrates is of significant interest to investors, as naturally the outcome relies on a business being able to generate more earnings from growth than the debt costs to fund it. If the plan pays off, shareholders and investors can profit, but if the debt and interest completely swallow any profits, it can cause shares to take a nosedive and put the company’s financial stability at risk. This is why the debt to equity ratio can be such an important metric.
In general, the debt to equity ratio is used to evaluate long-term leverage, as changes in long-term debt tend to have the biggest effect on this metric. There are other ratios that can be better suited to evaluating a company’s short-term leverage, such as the cash ratio or current ratio.
How to calculate debt to equity ratio
To calculate the debt to equity ratio, you simply divide a company’s total liabilities by the total shareholder equity.
A company’s liabilities are the money it owes to other parties. This includes short-term liabilities such as wages to staff, bills for suppliers, interest on debts, utilities, and long-term liabilities such as debts that are due in more than a year. There are also elements that can skew the accuracy of the ratio, such as items on the balance sheet that don’t necessarily fit into debt or equity, such as retained earnings or losses, or intangible assets, so more research would be needed or adjustments made to get a more useful and accurate debt to equity ratio. This can sometimes be done by including elements like growth expectations or profit performance.
The debt to equity ratio in practice
When using the debt to equity ratio to appraise a company’s financial leverage, it’s important to put it into an industry context. A normal ratio can look very different across various industries and types of business, due to different growth rates, capital needs, and other factors.
Companies that produce everyday consumer products tend to have high debt to equity ratios because they usually have a stable and reliable income and therefore borrow money cheaply. Likewise, utility providers can also command stable income streams and grow slowly over time, commonly giving them a high debt to equity ratio.
Compound interest FAQ's
What is a good debt to equity ratio?
This will look different for different types of businesses, but a debt to equity ratio below 1.0 could broadly be seen as safe, while a ratio above 2.0 would represent a risk. A high ratio can be considered normal for many types of businesses, however, and a low ratio could even indicate a lack of expansion and growth.
What industries have high debt to equity ratio?
Businesses that produce essential consumer products tend to have high debt to equity ratios as they have reliable income and can borrow cheaply to fuel growth. The banking sector also tends to show a lot of high debt to equity ratios as banks naturally take on a lot more debt. Industries that require regular use of large amounts of capital may also show high ratios, such as manufacturers or the airline industry.
What does a high debt to equity ratio mean?
A high debt to equity ratio can show that a company has a larger amount of liabilities than shareholder equity, perhaps due to taking on a large amount of debt to fuel an expansion, or because of a heavy investment in new equipment or staff. What this means for the financial health of a company will depend on the nature of the business and the industry in which they operate, as it’s natural for some types of business to have a high debt to equity ratio.
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