What’s it: The debt-to-equity ratio is a leverage ratio by compares the relative proportions of a company’s capital structure. Specifically, it measures how much debt capital is compared to equity capital.
A higher ratio indicates higher leverage and is considered riskier because, after all, high debt levels increase the burden on the future – to pay interest and principal. For example, a ratio of more than one means the company relies more on debt than equity.
However, what is the ideal debt-to-equity ratio can vary between industries. For this reason, we must compare it with companies in the same industry if we want to make an apple-to-apple comparison.
Why is the debt-to-equity ratio important?
The debt-to-equity ratio is a metric often seen for examining financial leverage. It tells us the extent to which a company relies on debt – rather than equity – to finance its operations.
A company’s capital structure comes from two sources: equity capital and debt capital. If companies rely more on debt than equity, they are highly leveraged. Therefore, we consider them to have a higher financial risk.
Why is it riskier? Let’s dissect a little about debt.
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Unlike equity capital, debt requires a future cash outflow. Take bonds as an example. The company has to pay interest (coupons) regularly, for example, monthly, quarterly, or semi-annually – and as such, it represents a fixed cost – and pay off the principal when it is due.
Debt must be paid, even when the company is at a loss or not generating revenue. Failure to do so could prompt creditors to file for bankruptcy against the company.
And, the higher the debt, the greater the burden to be paid. Financial risk increases because higher debt leads to decreased repayment ability and higher default risk.
In addition, the company’s finances also become inflexible if it has too much debt. The company finds it difficult to get new loans cheaper. On the other hand, more dollars on books are allocated to repaying debt than retained as internal capital.
How to calculate the debt-to-equity ratio?
Calculating the debt-to-equity ratio requires us to divide total debt by total equity. Total debt refers to interest-bearing debt such as bank loans and bonds, both short-term and long-term. We can find these data on the balance sheet.
In specific cases, some people may use total liabilities as the numerator instead of total debt. That’s especially if the company has no interest-bearing debt. But, please remember some liability accounts are accrued or do not generate cash outflow for settlement. Thus, using total liabilities in the calculation can be misleading.
- Debt‐to‐equity ratio = Total debt / Total equity
Take a simple illustration. A company has $6 million in assets and $2 million in liabilities. In the liabilities section, the company reported $500,000 in short-term interest debt and $1 million in long-term interest debt.
From the above case, we calculate total equity by subtracting liabilities from total assets, so, we get the figure equal to $4 million = $6 million – $2 million. Then, applying the above formula, we get a debt-to-equity ratio of 0.38 = ($500,000 + $1 million) / $4 million.
How to interpret the debt-to-equity ratio?
A high debt-to-equity ratio is undesirable because it indicates a higher financial risk. In contrast, a low ratio indicates the company relies more on equity than debt. Then, a ratio equal to 1.0 indicates the company has debt and equity in the same proportion in its capital structure.
Debt-to-equity ratios below 1.0 are sometimes considered relatively safe, while those equal to or more than 2.0 are considered risky. However, we cannot equate it for all companies. Therefore, we should further examine the nature of their business and their industry, which influences the variation in this ratio.
What does a high ratio imply?
A high ratio is risky because the company has to spend money regularly – and in large amounts – to pay interest and principal. Moreover, they must continue to do so even when they are at a loss or not generating revenue. Otherwise, creditors can file for bankruptcy against the company and force the company to liquidate assets to pay off debt.
Another consequence is low financial flexibility. First, companies must allocate more money to repay debt rather than being held as internal capital to finance working capital or long-term investments.
Second, prospective creditors are reluctant to provide financing to the company. A high ratio reflects a high risk of default. Thus, it is more difficult for the company to get the new debt to grow the business.
Even if the company can get new debt, it will be at a high cost. This is because creditors will demand higher interest to compensate for higher default risk. As a result, the debt burden is piling up.
But, let’s say the company could invest that expensive debt and generate more revenue. In that case, applying for debt may not be a problem for the company. The company can generate higher income increases than the additional costs of debt. Thus, its ability to pay does not deteriorate.
What is the ideal debt-to-equity ratio?
The ideal or safe debt-to-equity ratio varies between businesses. Companies in different industries could have vastly different average ratios. For example, utility companies usually have high ratios. Nonetheless, it is also accompanied by good payability because it has a steady cash inflow.
Likewise, banks also have a high debt ratio. Understandably, they take deposits from the public and distribute them as loans by taking the difference in interest as profit. And, the deposit they book is an interest-bearing debt. But, again, it doesn’t always cause problems.
Companies in mature industries usually also take on high debt because they are supported by stable cash inflows. That contrasts with those operating in growing industries, which need more money to spur business growth.
New companies may also take on less debt than established companies. That’s because they do not yet have a stable income or even still bear losses. As businesses and incomes grow, they take on debt.
Finally, companies in defensive industries have steady cash inflows – and, therefore, tend to take on more debt than those operating in cyclical industries.
What to read next
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- Debt-to-Capital Ratio: How to Calculate and Interpret
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- Assets-to-Equity Ratio: Calculation and Interpretation
- Interest Coverage Ratio: How to Calculate and Interpret it
- Fixed Charge Coverage Ratio: Calculation and Interpretation