The Debt-to-equity Ratio Formula What It Is and How to Use It

Debt-to-equity (D/E) ratio can help investors identify highly leveraged companies that may pose risks during business downturns. Investors can compare a company’s D/E ratio with the average for its industry and those of competitors to gain a sense of a company’s reliance on debt. In fact, debt can enable the company to grow and generate additional income. But if a company has grown increasingly reliant on debt or inordinately so for its industry, potential investors will want to investigate further. Moreover, there needs to be more clarity about whether to count preferred stock as debt. This is especially important in industries that use a lot of preferred stock, like real estate investment trusts (REITs).

This means that for every dollar of equity, Company A has two dollars of debt. This might be concerning for investors and creditors, as it indicates a high level of leverage and potential financial risk. Company A has total liabilities of $500,000 and shareholder’s equity of $250,000. However, to achieve growth, you might need to borrow money to make the most of your resources. This strategy can help you and your shareholders achieve the desired returns.

When to Use the Debt-To-Equity Ratio?

The goal for a business is not necessarily to have the lowest possible ratio. “A very low debt-to-equity ratio can be a sign that the company is very mature and has accumulated a lot of money over the years,” says Lemieux. On the other hand, a business could have $900,000 in debt and $100,000 in equity, so a ratio of 9. “In a case like that, the lenders almost completely financed the business,” says Lemieux. “It’s a very low-debt company that is funded largely by shareholder assets,” says Pierre Lemieux, Director, Major Accounts, BDC. If a company has a ratio of 1.25, it uses $1.25 in debt financing for every $1 of debt financing.

  • For example, you have a $2,000 bank loan, $2,500 in accounts payables to vendors, and fixed payments of $500.
  • So, for example, you subtract the balance on the operating line of credit and the amounts owed to suppliers from the liabilities.
  • Debt ratio is a metric that measures a company’s total debt, as a percentage of its total assets.
  • Since equity is equal to assets minus liabilities, the company’s equity would be $800,000.

However, this will also vary depending on the stage of the company’s growth and its industry sector. Newer and growing companies often use debt to fuel growth, for instance. D/E ratios should always be considered on a relative basis compared to industry peers or to the same company at different points in time.

One of the most important aspects of your business for you to analyze is its capital structure, which refers to the mix of debt and equity used to finance its operations. If you run a business, it’s good to know that the Debt-to-Equity Ratio has some limitations. Different industries have different needs for money and growth, so what’s okay in one industry might be different. For instance, utility companies usually have high D/E ratios because they make steady money and must invest a lot. The Debt-to-Equity Ratio doesn’t consider qualitative factors such as the company’s business model, competitive advantage, or management’s ability to handle debt.

Accounting Newbie?

Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. Upon plugging those figures into our formula, the implied D/E ratio is 2.0x. Pete Rathburn is a copy editor and fact-checker with expertise in economics and personal finance and over twenty years of experience in the classroom.

Create a free account to unlock this Template

Lenders want to see that a prospective borrower is able to make payments on time, and is not clouded by a significant amount of debt already. The debt-to-equity ratio measures your company’s total debt relative to the amount originally invested by the owners and the earnings that have been retained over time. Companies that are heavily capital intensive may have higher debt to equity ratios while service firms will have lower ratios.

Specific to Industries

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. The result means that Apple had $1.80 of debt for every dollar of equity. It’s important to compare the ratio with that of other similar companies. To get a clearer picture and facilitate comparisons, analysts and investors will often modify the D/E ratio.

Limitations of Debt to Equity Ratio

This ratio provides insights into the financial leverage a company possesses and its ability to repay its debts. It is a measure of the proportion of the company’s funding that comes from debt (borrowed money) compared to equity (owners’ investments). The debt-to-equity ratio measures how much debt a company is using to finance its operations. A higher debt-to-equity ratio indicates that a company has higher debt, while a lower debt-to-equity ratio signals fewer debts. Generally, a good debt-to-equity ratio is less than 1.0, while a risky debt-to-equity ratio is greater than 2.0. But this is relative—there are some industries in which companies regularly leverage more debt.

In the majority of cases, a negative D/E ratio is considered a risky sign, and the company might be at risk of bankruptcy. However, it could also mean the company issued shareholders significant dividends. In general, if a company’s D/E ratio is too high, that signals that the company is at risk of financial distress (i.e. at risk of being unable to meet required debt obligations). The two components used to calculate the debt-to-equity ratio are readily available on a firm’s balance sheet.

Dodaj komentarz