Debt-to-Equity Ratio Explained: Whats a Healthy Level?

Since Debt is cheaper than Equity, it generally benefits companies to use Debt up to a reasonable level because it provides cheaper financing for their operations. Using the D/E ratio as part of a broader analysis—along with cash flow, profitability, revenue trends, and industry outlook—may provide more meaningful insights. For example, utility companies often carry D/E ratios above 2.0 but still perform well because their services are essential, and they operate under government regulation. They can pass interest costs to consumers, making debt more manageable. In the majority of cases, a negative D/E ratio is considered a risky sign, and the company might be at risk of bankruptcy.

While this may help reduce financial risk, it might also mean fewer opportunities to leverage borrowing for growth—especially when interest rates are low. In this guide, we’ll break down what the D/E ratio is, how to calculate it, and how investors can interpret it to assess a company’s financial health. Calculating the debt to equity ratio for banks requires adjustments due to their unique business models.

The second company’s interest expense and cost of capital are therefore likely higher. Interest expense will rise if interest rates are higher when the long-term debt comes due and has to be refinanced. Both IFRS and GAAP require that retained earnings be included in the denominator of the debt-to-equity ratio. Retained earnings, also known as retained surplus or accumulated earnings, are a component of shareholder equity and should be included in the denominator of the debt-to-equity ratio. Retained earnings represent the portion of a company’s net income that is not distributed as dividends and is instead kept in the company’s reserves. It is also worth noting that, some industries or sectors like utilities or regulated industries have a lower risk and thus have a lower debt-to-equity ratio.

Examples of D/E Ratio calculations for different companies

• For this reason, it’s important to understand the norms for the industries you’re looking to invest in, and, as above, dig into the larger context when assessing the D/E ratio.
• A negative debt-to-equity ratio would also not be meaningful because it would indicate that the company has more debt than equity, which is not possible.
• Treasury Accounts.Investment advisory services for Treasury Accounts are provided by Public Advisors LLC (“Public Advisors”), an SEC-registered investment adviser.
• Including it in the equity portion of the D/E ratio will increase the denominator and lower the ratio.

While a debt to equity ratio below 1 generally signifies lower financial risk, it’s not universally “good.” The ideal ratio varies significantly by industry. A low ratio might indicate a lack of debt financing to fuel expansion; in some cases, a low D/E might limit growth opportunities. The debt to equity ratio is a key financial metric calculated by dividing a company’s total liabilities by its shareholders’ equity. A lower debt to equity ratio usually implies a more financially stable business. Companies with a higher debt to equity ratio are considered more risky to creditors and investors than companies with a lower ratio. Since debt financing also requires debt servicing or regular interest payments, debt can be a far more expensive form of financing than equity financing.

Why is Debt to Equity Ratio Important?

Like the D/E ratio, all other gearing ratios must be examined in the context of the company’s industry and competitors. They do so because they consider this kind of debt to be riskier than short-term debt, which must be repaid in one year or less and is often less expensive than long-term debt. And, when analyzing a company’s debt, you would also want to consider how mature the debt is as well as cash flow relative to interest payment expenses. One limitation of the D/E ratio is that the number does not provide a definitive assessment of a company. In other words, the ratio alone is not enough to assess the entire risk profile. The general consensus is that most companies should have a D/E ratio that does not exceed 2 because a ratio higher than this means they are getting more than two-thirds of their capital financing from debt.

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• The debt-to-equity ratio is most useful when it’s used to compare direct competitors.
• Plans are self-directed purchases of individually-selected assets, which may include stocks, ETFs and cryptocurrency.
• The D/E ratio is a type of gearing ratio, comprising a group of financial ratios, which compares a company’s equity to its borrowed funds or liabilities.
• However, this may not necessarily mean that the company is struggling to meet its financial obligations.
• Additionally, the debt-to-asset ratio falls under the category of leverage ratios.

In the financial industry (particularly banking), a similar concept is equity to total assets (or equity to risk-weighted assets), otherwise known as capital adequacy. While the D/E ratio is primarily used for businesses, the concept can also be applied to personal finance to assess your own financial leverage, especially when considering loans like a mortgage or car loan. 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 a loan default or bankruptcy.

The Debt-to-Equity Ratio in Valuation and Financial Modeling: Quick Risk Assessment?

Maintaining a balanced ratio is key to long-term financial stability and growth. Thus, analysts might be subjective in their interpretation and judgment, resulting in possible variations on how they classify different assets as either debt or equity. Preferred stock for example may be categorised by some as equity, while a preferred dividend may be perceived by others as debt, due to its value and limited liquidation rights. In the technology industry, whose operations are typically not capital-intensive, the normal range for a D/E ratio is lower, averaging around 0.5.

Below is an overview of the debt-to-equity ratio, including how to calculate and use it. The higher the number, the greater the reliance a company has on debt to fund growth. Find out what a debt-to-equity ratio is, why it is important to a business, and how to calculate it. If a company cannot pay the interest and principal on its debts, whether as loans to a bank or in the form of bonds, it can lead to a credit event.

The Current Ratio includes all current assets, while the Quick Ratio excludes inventory, offering a stricter measure of short-term liquidity. The long-term D/E ratio is not as commonly used as the D/E ratio, as it does not provide a comprehensive view of all the liabilities a company is due to pay. It tends to be used in conjunction with the D/E ratio to obtain a view on how much a company’s billing period date on subscription invoices liabilities are long-term, as opposed to such liabilities being due within a year.

This ratio can help you gauge how risky a company might be when it comes to taking on additional debt. However, context is crucial—what may be considered “high” for one industry could be normal in another. Assume a company has $100,000 of bank lines of credit and a $500,000 mortgage on its property. It shows how much debt a company uses to finance its operations relative to what is prepaid rent its importance in the accounting sphere its own capital. In our debt-to-equity ratio (D/E) modeling exercise, we’ll forecast a hypothetical company’s balance sheet for five years. While not a regular occurrence, it is possible for a company to have a negative D/E ratio, which means the company’s shareholders’ equity balance has turned negative.

The D/E ratio is a financial metric that measures the proportion of a company’s debt relative to its shareholder equity. The ratio offers insights into the company’s debt level, indicating whether it uses more debt or equity to run its operations. An essential part of the debt-to-asset ratio equation is total assets.

InvestingPro offers detailed insights into companies’ D/E Ratio including sector benchmarks and competitor analysis. Overall, the D/E ratio provides insights highly useful to investors, but it’s important to look at the full picture when considering investment opportunities. Banks often have high D/E ratios because they borrow capital, which they loan to customers. how to create a strategic fundraising plan that you’ll actually stick to However, in this situation, the company is not putting all that cash to work.

What is the Debt to Equity Ratio?

A high debt-to-equity (D/E) ratio indicates elevated financial risk. It suggests that a company relies heavily on borrowing to fund its operations, often due to insufficient internal finances. Essentially, the company is leveraging debt financing because its available capital is inadequate. This ratio compares a company’s total liabilities to its shareholder equity. It is widely considered one of the most important corporate valuation metrics because it highlights a company’s dependence on borrowed funds and its ability to meet those financial obligations.

The data required to compute the debt-to-equity (D/E) ratio is typically available on a publicly traded company’s balance sheet. However, these balance sheet items might include elements that are not traditionally classified as debt or equity, such as loans or assets. In general, a lower D/E ratio is preferred as it indicates less debt on a company’s balance sheet.

Conversely, a low ratio suggests more conservative financing but may signal missed growth opportunities. A relatively high D/E ratio is commonplace in the banking and financial services sector. Banks carry higher amounts of debt because they own substantial fixed assets in the form of branch networks. Higher D/E ratios can also be found in capital-intensive sectors that are heavily reliant on debt financing, such as airlines and industrials. It’s a highly regulated industry that makes large investments typically at a stable rate of return, generating a steady income stream, so utilities borrow heavily and relatively cheaply.

This kind of financial structure is often seen in capital-intensive industries—such as utilities or telecom—where borrowing is commonly used to fund infrastructure and long-term projects. While this level of debt can support expansion, it may also introduce more financial obligations. The debt-to-equity ratio may offer a snapshot of a company’s financial leverage. A high ratio could suggest that a company is financing a significant portion of its operations through debt. A lower ratio might imply that the company is using more equity to support its activities.