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. As noted above, it’s also important to know which type of liabilities you’re concerned about — longer-term debt vs. short-term debt — so that you plug the right numbers into the formula. Other companies that might have higher ratios include those that face little competition and have strong market positions, and regulated companies, like utilities, that investors consider practice ignition relatively low risk. As a general rule of thumb, a good debt-to-equity ratio will equal about 1.0.
- Specifically, preferred stock with dividend payment included as part of the stock agreement can cause the stock to take on some characteristics of debt, since the company has to pay dividends in the future.
- This in turn makes the company more attractive to investors and lenders, making it easier for the company to raise money when needed.
- The company must also hire and train employees in an industry with exceptionally high employee turnover, adhere to food safety regulations for its more than 18,253 stores in 2022.
- For instance, in capital intensive industries like manufacturing, debt financing is almost always necessary to help a business grow and generate more profits.
Debt to Equity Ratio Calculator (D/E)
This reflects a certain ambiguity between the terms debt and liabilities that depends on the circumstance. The debt-to-equity ratio, for example, is closely related to and more common than the debt ratio, instead, using total liabilities as the numerator. Last, the debt ratio is a constant indicator of a company’s financial standing at a certain moment in time.
How Can the Debt-to-Equity Ratio Be Used to Measure a Company’s Risk?
A debt-to-equity-ratio that’s high compared to others in a company’s given industry may indicate that that company is overleveraged and in a precarious position. Companies that don’t need a lot of debt to operate may have debt-to-equity ratios below footing in accounting 1.0. A company’s ability to cover its long-term obligations is more uncertain, and is subject to a variety of factors including interest rates (more on that below). Hence they are paid off before the owners (shareholders) are paid back their claim on the company’s assets. Determining whether a debt-to-equity ratio is high or low can be tricky, as it heavily depends on the industry.
Specific to Industries
Ultimately, businesses must strike an appropriate balance within their industry between financing with debt and financing with equity. If the company has borrowed more and it exceeds the capital it owns in a given moment, it is not considered as a good metric for the company in question. Then what analysts check is if the company will be able to meet those obligations. The debt-to-equity ratio (D/E ratio) depicts how much debt a company has compared to its assets. As you can see, company A has a high D/E ratio, which implies an aggressive and risky funding style. Company B is more financially stable but cannot reach the same levels of ROE (return on equity) as company A in the case of success.
If a company is using debt to finance its growth, this can potentially provide higher return on investment for shareholders, since the company is generating profits from other people’s money. A high debt to equity ratio means that a company is highly dependent on debt to finance its growth. 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.
Companies in the consumer staples sector tend to have high D/E ratios for similar reasons. Short-term debt also increases a company’s leverage, of course, but because these liabilities must be paid in a year or less, they aren’t as risky. A negative D/E ratio indicates that a company has more liabilities than its assets.
However, industries may have an increase in the D/E ratio due to the nature of their business. For example, capital-intensive companies such as utilities and manufacturers tend to have higher D/E ratios than other companies. The current ratio measures the capacity of a company to pay its short-term obligations in a year or less.
Financial leverage simply refers to the use of external financing (debt) to acquire assets. With financial leverage, the expectation is that the acquired asset will generate enough income or capital gain to offset the cost of borrowing. By contrast, higher D/E ratios imply the company’s operations depend more on debt capital – which means creditors have greater claims on the assets of the company in a liquidation scenario. The formula for calculating the debt-to-equity ratio (D/E) is equal to the total debt divided by total shareholders equity. In some cases, companies can manipulate assets and liabilities to produce debt-to-equity ratios that are more favorable.
Higher D/E ratios can also tend to predominate in other capital-intensive sectors heavily reliant on debt financing, such as airlines and industrials. A D/E ratio of 1.5 would indicate that the company in question has $1.50 of debt for every $1 of equity. Because equity is equal to assets minus liabilities, the company’s equity would be $800,000. What counts as a “good” debt-to-equity (D/E) ratio will depend on the nature of the business and its industry. Generally speaking, a D/E ratio below 1 would be seen as relatively safe, whereas values of 2 or higher might be considered risky. Companies in some industries, such as utilities, consumer staples, and banking, typically have relatively high D/E ratios.
If you want to express it as a percentage, you must multiply the result by 100%. 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.