Debt-to-equity (D/E) ratio is a formula used to measure a company’s total expenses in relation to its total value. A company’s total value, or equity, is the aggregated purchase value of the company stock. Examples of the kind of overhead expenses included in D/E ratios are:
- Debt service
- Outstanding invoices
- Employee salary
- 401(k) contributions
- Taxes
- Office rent
- Insurance
Overhead and expenses eat into company profits and shrink investor dividends. This is the most obvious reason investors prefer buying stock in companies that are not loaded down by a high D/E ratio.
Debt-to-Equity Ratio Formula
Below, you will find a simple formula for calculating a company’s debt-to-equity ratio.
Total Debts ÷ Total Share Value = Debt-to-Equity Ratio
Sample Equation:
$10,000,000 debts ÷ $25,000,000 total share value = 0.40 Debt-to-Equity Ratio
Debt-to-Equity Ratio Example
Financial analysts are attuned to D/E ratios as an indicator of a company’s overall health. A high D/E ratio is not necessarily a sign of a poorly managed company. Astute analysts realize D/E ratio doesn’t exist in a vacuum and will compare a company’s D/E ratio to that of similar companies in the same industry.
Some companies are highly leveraged as a consequence of the business that they’re in. Real estate development, for example, typically requires developers to borrow heavily to finance projects before they pay off. As long as the development company’s D/E ratio doesn’t grossly exceed the average industry standard, an analyst might still consider it to be a solid investment.
Context Matters
The debt-to-equity ratio is a metric that helps assess a company’s financial health by comparing its liabilities to its total value. It is important to consider industry norms when interpreting this ratio, as different sectors may naturally have higher leverage. Investors should compare a company’s D/E ratio to industry peers for a more accurate assessment of its financial stability.
Frequently Asked Questions
What does a D/E ratio of 1.5 indicate?
A debt-to-equity ratio of 1.5 indicates that a company has more debt than equity. This means that the company relies more on borrowed funds to finance its operations and growth rather than using its own capital. A higher D/E ratio can indicate higher financial risk for the company, as it may have difficulty meeting its debt obligations in the event of financial difficulties.
What industries have high D/E ratios?
Industries with high debt-to-equity ratios include telecommunications, utilities, energy, construction and manufacturing. These industries require large investments in infrastructure and equipment, leading to higher levels of debt compared to equity.
Is a higher debt-to-equity ratio better?
The optimal debt-to-equity ratio for a company depends on its circumstances and goals. A higher ratio can indicate more debt and financial risk, but it can also suggest the use of leverage for growth and potentially higher returns. Factors such as industry norms, market conditions and debt management ability play a role in determining the ideal ratio.