The cost of debt and a company’s ability to service it can vary with market conditions. As a result, borrowing that seemed prudent at first can prove unprofitable later under different circumstances. Every corporate finance professional needs to understand capital structure—the mix of debt and equity that funds a company’s growth, operations, and strategic moves. In this episode of Corporate Finance Explained, we break down the key concepts, trade-offs, and real-world examples of how companies optimize their capital structure. Understanding the debt to equity ratio is essential for anyone dealing with finances, whether you’re an investor, a financial analyst, or a business owner. It shines a light on a company’s financial structure, revealing the balance between debt and equity.
For example, utility companies might be required to use leverage to purchase costly assets to maintain business operations. But utility companies have steady inflows of cash, and for that reason having a higher D/E may not spell higher risk. While acceptable D/E ratios vary by industry, investors can still use this ratio to identify companies in which they want to invest. First, however, it’s essential to understand the scope of the industry to fully grasp how the debt-to-equity ratio plays a role in assessing the company’s risk. This ratio helps indicate whether a company has the ability to make interest payments on its debt, dividing earnings before interest and taxes (EBIT) by total interest. Most of the information needed to calculate these ratios appears on a company’s balance sheet, save for EBIT, which appears on its profit and loss statement.
If the debt to equity ratio gets too high, the cost of borrowing will skyrocket, as will the cost of equity, and the company’s WACC will get extremely high, driving down its share price. However, that’s not foolproof when determining a company’s financial health. Some industries, like the banking and financial services sector, have relatively high D/E ratios, and that doesn’t mean these companies are in financial distress. 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. In the event of a default, the company may be forced into bankruptcy.
Additionally, the ratio should be analyzed with other financial metrics and qualitative factors to get a comprehensive view of the company’s financial health. For a mature company, a high D/E ratio can be a sign of trouble that the firm will not be able to service its debts and can eventually lead to a credit event such as default. For a growing company, a high D/E could be a healthy sign of expansion. In all cases, D/E ratios should be considered relative to a company’s industry and growth stage. A company’s management will, therefore, try to aim for a debt load that is compatible with a favorable D/E ratio in order to function without worrying about defaulting on its bonds or loans. The debt-to-equity ratio (D/E) is calculated by dividing the total debt balance by the total equity balance.
What Is Leverage?
In some cases, creditors limit the debt-to-equity ratio a company can have as part of their lending agreement. Such an agreement prevents the borrower from taking on too much new debt, which could limit the original creditor’s ability to collect. In order to calculate the debt-to-equity ratio, you need to understand both components.
For example, manufacturing companies tend to have a ratio in the range of 2–5. This is because the industry is capital-intensive, requiring a lot of debt financing to run. As an example, the furnishings company Ethan Allen (ETD) is a competitor to Restoration Hardware. The 10-K filing for Ethan Allen, in thousands, lists total liabilities as $312,572 and total shareholders’ equity as $407,323, which results in a D/E ratio of 0.76. For growing companies, the D/E ratio indicates how much of the company’s growth is fueled by debt, which investors can then use as a risk measurement tool. Founded in 1993, The Motley Fool is a financial services company dedicated to making the world smarter, happier, and richer.
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Lower LTVs represent less risk for both the lender and the homeowner. This situation is not a problem as long as the buyer can afford the mortgage payments and doesn’t need to sell. They can simply wait out the downturn until values eventually come back up. However, if they need to sell during this period, the sales price would not cover the loan balance. Mortgage insurance is a policy that protects the lender if the borrower defaults on the loan.
They may note that the company has a high D/E ratio and conclude that the risk is too high. It’s clear that Restoration Hardware relies on debt to fund its operations to a much greater extent than Ethan Allen, though this is not necessarily a bad thing. You can find the balance sheet on a company’s 10-K filing, which is required by the US Securities and Exchange Commission (SEC) for all publicly traded companies. On the other hand, a comparatively low D/E ratio may indicate that the company is not taking full advantage what is owner’s equity of the growth that can be accessed via debt. Liabilities are items or money the company owes, such as mortgages, loans, etc.
Ratio Calculators
Restoration Hardware’s cash flow from operating activities has consistently grown over the past three years, suggesting the debt is being put to work and is driving results. Additionally, the growing cash flow indicates that the company will be able to service its debt level. You can find the inputs you need for this calculation on the company’s balance sheet.
Use Multiple Metrics to Calculate Leverage and Determine Risk
The Debt to Equity Ratio (D/E ratio) is one of the most commonly used financial metrics to evaluate a company’s financial leverage. This ratio compares a company’s total liabilities to its shareholders’ equity, helping investors understand the extent to which a business relies on debt to finance its operations. Unlike the debt-assets ratio which uses total assets as a denominator, the D/E Ratio uses total equity.
Understanding Loan-to-Value Ratios
- Because often it is cheaper to use debt to finance purchases of equipment, capital improvements, expansions, etc than it is to use equity.
- For example, utility companies might be required to use leverage to purchase costly assets to maintain business operations.
- Larger companies can sometimes carry higher debt levels without too much risk.
- The D/E ratio represents the proportion of financing that came from creditors (debt) versus shareholders (equity).
- It’s easy to get started when you open an investment account with SoFi Invest.
- Gearing ratios constitute a broad category of financial ratios, of which the D/E ratio is the best known.
When interpreting the D/E ratio, you always need to put it in context by examining the ratios of competitors and assessing a company’s cash flow trends. Some investors also like to compare a company’s D/E ratio to the total D/E of the S&P 500, which was approximately 1.58 in late 2020 (1). 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. As this figure rises, the debt costs become more burdensome. It’s useful to compare ratios between companies in the same industry, and you should also have a sense of the median or average D/E ratio for the company’s industry as a whole.
- It’s particularly important because many properties will have different taxes and fees, which can obscure true ROI formulas when determining the profitability of real estate.
- Banks carry higher amounts of debt because they own substantial fixed assets in the form of branch networks.
- You can find the inputs you need for this calculation on the company’s balance sheet.
- If interest rates are higher when the long-term debt comes due and needs to be refinanced, then interest expense will rise.
- The D/E ratio is calculated by dividing a company’s total liabilities by its shareholder’s equity.
A D/E ratio of about 1.0 to 2.0 is considered good, depending on other factors like the industry the company is in. But a D/E ratio above 2.0 — i.e., more than $2 of debt for every dollar of equity — could be a red flag. Again, context is everything and the D/E ratio is only one indicator of a company’s health. Investors who want to take a more hands-on approach to investing, choosing individual stocks, may take a look at the debt-to-equity ratio to help determine whether a company is a risky bet. Debt-to-equity ratio is just one piece of the puzzle when it comes to evaluating stocks. Whether the ratio is high or low is not the bottom line of whether one should invest in a company.
The D/E ratio is part of the gearing ratio family and is the about education tax credits most commonly used among them. The D/E ratio is much more meaningful when examined in context alongside other factors. Therefore, the overarching limitation is that ratio is not a one-and-done metric. These industry-specific factors definitely matter when it comes to assessing D/E.
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 interest rates on business loans can be relatively low, and are tax deductible. That makes debt an attractive way to fund business, especially compared to the potential returns from the stock market, which can be volatile. But let’s say Company A has $2 million in long-term liabilities, and $500,000 in short-term liabilities, whereas Company B has $1.5 million in long-term debt and $1 million in short term debt. The long-term D/E ratio for Company A would be 0.8 vs. 0.6 for company B, indicating a higher risk level.
Not only that, companies with a high debt-to-equity ratio may have a hard time working with other lenders, partners, or even suppliers, who may be afraid they won’t be paid back. • Different industries have varying acceptable D/E ratios, with capital-intensive sectors often operating with higher ratios due to their borrowing needs for growth. Assessing whether a D/E ratio is too high or low means viewing it in context, such as comparing to competitors, looking at industry averages, and analyzing cash flow. Like the D/E ratio, all other gearing ratios must be examined in the context of the company’s industry and competitors. If a D/E ratio becomes negative, a company may have no choice but to file for bankruptcy.
The debt-to-asset ratio measures how much of a company’s assets are financed by debt, while the debt-to-equity ratio accounts for shareholder capital. With debt-to-equity ratios and debt-to-assets ratios, lower is generally favored, but the ideal can vary by industry. Although it will increase their D/E ratios, companies are more likely to take on debt when interest rates are low to capitalize on growth potential and finance operations. Conversely, companies are less likely to take on new debt when interest rates are high, as it’s harder for that borrowing to yield a positive return. Conservative investors may prefer companies with lower D/E ratios, especially if they pay top 10 business blogs and why they are successful dividends. However, a lower D/E ratio isn’t automatically a positive sign — relying on equity to finance operations can be more expensive than debt financing.
Debt Equity Ratio Template
Publicly traded companies will usually share their balance sheet along with their regular filings with the Securities and Exchange Commission (SEC). The debt-to-equity (D/E) ratio is a measurement of a company’s financial leverage, that is, how much the company has borrowed vs how much the company’s owners have in equity. The D/E ratio is calculated by dividing a company’s total liabilities by its shareholder’s equity.