Wondering what a debt-to-equity ratio is? In broad terms, this measurement is a key indicator of financial flexibility and strength, showing a company’s ability to cover expenses and operating costs, and weather setbacks.
In short, a D/E ratio reveals the amount of debt—or liabilities—a company carries in relation to how much shareholder equity it has. Shareholder equity simply means how much in assets the owners would have after their debt has been paid off.
If a company has a high debt-to-equity ratio, it is considered highly leveraged. This often means it has borrowed from lenders or sold bonds, and has used the capital to purchase assets. These assets are bought with the intention of increasing profits and earning more than enough to repay the borrowed money.
If you're an investor, looking at a company's D/E ratio can help you determine a company's ability to repay its debt. It also indicates how much equity an investor might receive if the company were sold or liquidated. Although there are advantages and disadvantages to both tapping into debt or tapping into equity to run a business, typically, for the investor, lower D/E ratios suggest greater financial soundness.
How to calculate the debt-to-equity ratio
The debt-to-equity ratio formula is fairly simple:
Total liabilities / total shareholder's equity = debt-to-equity
This ratio is typically expressed in numerical form, such as 0.6, 1.2, or 2.0.
Total debt includes short-term and long-term liabilities. Short-term liabilities are debt that typically are paid off within a year—think rent, income taxes, and accounts payables. Long-term liabilities include any debt that is paid off in more than a year, typically things such as larger bank loans and bonds.
If you use Excel sheets frequently for your business, you can easily punch in a formula to calculate a D/E ratio:
1. Pop in the total debt and shareholder equity from the company’s balance sheet.
2. Put these numbers side-by-side in two cells on a spreadsheet.
3. Last, in the cell to the left of these two cells, put X/Y to get the D/E ratio.
Total debt: Cell D24
Shareholder equity: Cell D25
D/E Ratio (in Cell D23): D24/D25
Interpreting debt-to-equity ratio results
When a business has a D/E ratio that exceeds 1.0, it means that the company has more debt than assets. On the flip side, a D/E ratio of less than 1.0 shows a company's assets are greater than its debt load.
It's important to keep in mind that the D/E ratio has some limitations. For one, a business's leverage might be skewed by including or excluding preferred stock, contributions to retirement accounts, and so-called intangible assets. In turn, the ratio might not paint a complete or accurate picture of how much debt a company is actually carrying.
Sometimes, the calculations can feel like comparing apples to oranges; accounts in one company's balance sheet might look different or include different categories or transactions than another company's. In that case, adjustments might be made to the D/E ratios of different companies so they're more comparable.
Then there is the argument that leverage isn't enough to determine how risky a company might be for the investor. That's because leverage doesn't take into account low interest rates, which tend to make it less costly to borrow and repay debt.
Example of debt-to-equity ratio
A debt-to-equity ratio of 1.0 means that for every dollar of equity a company has, it uses $1 of debt to run the business. A debt-to-equity ratio of 2.0 means that for every $1 of equity a company has, it taps into $2 of financing. A debt-to-equity ratio of 0.75 equates to 75 cents borrowed for every $1 of equity.
Jennifer is an angel investor who has narrowed down to two the number of immersive art venues she wants to invest in. She takes a gander at the balance sheets of Snail Mail Art Unlimited and Pop Color Infusion. Snail Mail Art Unlimited has $40,000 in debt and $80,000 in assets—its D/E ratio is 0.50. Pop Color Infusion has $50,000 in debt and $50,000 in assets, which equates to a D/E ratio of 1.
Looking closely at Snail Mail Art Unlimited, Jennifer sees that it recently took out a loan to open a new venue, which could mean greater profitability in a few years. Meanwhile, Pop Color Infusion recently took out a bank loan because it needed the financing to cover outstanding invoices from vendors. While Snail Mail Art has long-term debt, Pop Color Infusion is carrying short-term debt. Although Pop Color's D/E ratio might change in the near future after it repays the loan, Snail Mail's D/E ratio might remain high for a while. That's because it might be years before it pays back the loan.
What is a good debt-to-equity ratio?
Defining a good debt-to-equity ratio is tricky because industry norms vary wildly. Plus, companies within the same industry, depending on their size, goods and services offered, and other variables could also lead to a different D/E ratio. However, across the board, if a company has a D/E ratio higher than 2.0, it’s a warning sign, regardless of industry.
Industries that require heavy capital investment tend to have higher D/E ratios than companies that sell services. For example, railroads and airlines spend a lot on materials and equipment, relying on borrowing that oftens leads to high D/E ratios. Amusement and entertainment companies, by comparison, tend to be less heavily indebted and have lower D/E readings.
If a debt-to-equity ratio is too high or too low, it could be problematic. An excessive D/E ratio might indicate that a company could have a hard time repaying its debt if profits dwindle. Or should the company be in financial straits and file for bankruptcy, it could have a tough time landing traditional financing, which it relied on in the past to run and grow the business.
However, a low D/E ratio could indicate that a business relies too heavily on its own assets. Used properly, debt is a powerful tool to help a company grow faster than it otherwise might by relying on internal capital. There's a bit of a happy medium when it comes to how much debt a company should shoulder.
What does it mean to have a negative debt-to-equity ratio?
It is possible for a company to have a negative debt-to-equity ratio. A negative D/E ratio means a company has more debt than assets. This could mean that the net worth of a company is less than zero. It could also mean that the interest of a loan used to make an investment is greater than any profits gained from the investment. This can serve as a smoke signal, warning investors and lenders that a company may be on shaky ground.
Why is debt to equity ratio important?
As an investor, a debt-to-equity ratio is important when figuring out which companies are shouldering more debt to finance and expanding their operations. Although there are pros and cons to using more debt or more equity, typically a lower D/E ratio means a company can pay its obligations more easily and keep the lights on should profits tumble. In turn, it could pose less of a risk to an investor. But a company with a low D/E also might not grow as fast.
There are nuances to a company's D/E ratio that should be taken into account. And a D/E ratio shouldn't be the only thing investors look at to determine a company’s risk. Ideally, investors should take a broad approach and evaluate all available financial data.