Debt to Equity RatioDefined with Examples, Formula & Calculations
What is the Debt-to-Equity Ratio?
The debt-to-equity ratio often referred to as the risk ratio, is a leverage ratio that evaluates the weight of a company’s total liabilities against its total shareholders’ equity.
This is an important financial ratio in corporate financing that can show the degree to which a company finances its operations through debt or equity financing, which by measuring against industry benchmarks can help to determine the capacity of a company to repay its debts in the event of financial setbacks.
Calculating the Debt-To-Equity Ratio
First of all, the formula to calculate the debt-to-equity ratio is:
Debt/Equity = Total Liabilities / Total Shareholders’ Equity
All of the information needed to find this ratio can be located on a company’s balance sheet.
However, this can become confusing because not all of the accounts within the balance sheet may be readily identifiable as equity or liability, in which case the ratio can easily become inaccurate.
Generally, to find a company’s actual D/E ratio, an investor will have to do some research to determine what to include.
For this reason, many investors use altered versions of the D/E ratio to make it easier to calculate the ratio correctly and then compare different investment opportunities.
In addition to using the D/E ratio for analyzing an investment opportunity by comparing it with profit performance, growth forecasts, and short-term leverage, it can offer considerably more useful information.
Calculating the Debt-to-Equity Ratio in Excel
There are many types of financial and accounting software that businesses can use to determine financial metrics, including the D/E ratio.
However, even those without expensive accounting software can calculate the D/E ratio with Microsoft Excel.
This can easily be performed by entering the data from the equity accounts and dividing them by liabilities.
However, the easiest way is to use a template for balance sheets that Microsoft provides, and by entering the data into this, Excel will automatically provide several financial ratios, including the D/E ratio.
What Can the Debt-To-Equity Ratio Tell You?
The D/E ratio provides a measurement of a company’s debt in relation to its total assets, and this is typically used as a way to analyze the extent to which a company has leveraged its assets through debt financing.
A high D/E ratio typically indicates greater risk because it indicates that the company has taken on greater debt in order to finance growth.
When used to finance growth, a high quantity of debt can indicate that a company is using it to create more earnings than it could have without the financing.
When the use of debt leads to greater returns than the cost of servicing the debt, then shareholders can expect a benefit.
However, if the cost of servicing debt costs more than the increase in income it creates, this may lower the value of shares.
Due to the fact that debt costs may change with market conditions, an unprofitable debt may be difficult to identify at first look.
Generally, long-term assets and liabilities will have the largest impact on the D/E ratio as a result of their size.
This account will normally be much larger than short term assets and liabilities, and as a result, if investors want to compare short term leverage or capacity to meet short term obligations, they may use other metrics such as the current ratio:
Current Ratio = Short Term Assets / Short Term Liabilities
Or the cash ratio:
Cash Ratio = Cash + Cash Equivalents / Short Term Liabilities
These ratios offer a far clearer picture of whether or not a company possesses the liquidity to cover its short-term obligations.
Modified Debt-to-Equity Ratios
The portion of the balance sheet dedicated to shareholders’ equity is equivalent to the value of all assets minus liabilities.
However, this is different from subtracting the debt associated with assets, and in order to avoid this issue, the D/E ratio is often modified in order to solve solely for long-term liabilities, which helps investors to focus on the important risks to a company.
This does not mean that short-term liabilities are unimportant, but due to the fact that they will be paid within 12 months, they do not pose the same risk.
For instance, picture a business with $100,000 in short-term liabilities such as accounts payable, salaries payable, and notes but only $50,000 in long-term liabilities such as loans.
Now, in contrast, picture a company with the reverse situation holding $50,000 in short-term liabilities and $100,000 in long-term liabilities.
If both of these companies hold $150,000 in shareholder’s equity, their D/E ratio will be the same at only 1.00.
However, they pose very different risks and costs.
Notably, since short-term debt is cheaper and is less responsive to changing interest rates, the second business’s cost of capital, as well as interest expense, will generally be higher.
Using the Debt-to-Equity Ratio for Personal Finances
The D/E ratio can be a useful tool for personal finances as well, and when it is used to analyze personal financial statements, it is referred to as the personal D/E ratio.
For this purpose, personal “equity” will be the difference between an individual’s assets and their debts or liabilities.
For personal finances, the formula for the personal D/E ratio will be:
Personal D/E = Total Liabilities / (Total Assets – Liabilities)
This formula is often used by lenders before offering a loan to individuals or small business owners.
This could be a valuable tool in judging whether or not a borrower will likely be able to repay a loan if their income were to decline.
As an example, if an individual were to lose their job, they may be able to continue making mortgage payments off of their savings or sell other assets to continue making payments until they are able to find another job.
However, if they had few assets and also needed to make payments on an auto loan, this is far less likely.
How is the Debt-to-Equity Ratio Different From the Gearing Ratio
Gearing ratios are actually an entire category of financial ratios, which include the D/E ratio.
In this context, gearing simply refers to the concept of financial leverage.
This is a central focus of gearing ratios which focus far more heavily on leverage than most other financial or accounting ratios.
As a result of this focus, most gearing ratios lack uniformity or precision.
This makes it hard to compare gearing ratios against other companies.
It is difficult to determine a “good” or “bad” degree of leverage.
After all, some leverage is generally assumed to be positive, but at what point does it simply place the company at an unnecessary degree of risk?
However, at its core, gearing is often defined separately from leverage.
While leverage is generally defined as the quantity of debt a company incurs for investments in order to achieve returns, gearing is often defined as the proportion of funding that a company acquires through borrowing related to the quantity it gains through equity.
Weaknesses of the Debt-to-Equity Ratio
The most significant drawback of the D/E ratio is the fact that it is of limited value when comparing companies across different industries.
Companies in separate industries may have extremely distinct capital requirements and stability of returns.
As a result, what might be a high ratio in one industry might be normal in another.
For example, a utility company typically requires considerable capital to start operating, which means that it will often have a difficult time raising the necessary capital through equity.
However, once it raises the capital to get started, often through debt, it typically will have a very stable income making it easy to borrow cheaply.
As a result, these companies will typically have a very high debt-to-equity ratio.
In addition to difficulty comparing across industries, many analysts measure these ratios in different ways.
Some analysts may include items as debt or equity that another might disregard, and this will often result in significantly different outputs.
As a result, these ratios may require adjustment to allow them to be easily compared.
Finally, the debt-to-equity ratio often uses volatile inputs such as market value and debt price, which are subject to frequent change.
This often requires smoothening these amounts, which will result in estimated values that may not be highly accurate.
Examples of the Debt-to-Equity Ratio
As of January 2021, Target had $36,808 million in total liabilities and $14,440 million in total equity.
This gives Target a D/E ratio of 2.5. Walmart has total liabilities of $164,965 million and total equity of $87,531 million.
This gives Walmart a D/E ratio of 1.88.
This would seem to show that Target has a higher level of risk due to its higher-leverage ratio.
However, it is best to check further before making any decisions based on this ratio.
As stated above, the ratio can vary depending on what is included in debts or liabilities.
Sometimes, the preferred equity can be reclassified, which can change the D/E ratio.
For example, if a company has $1 million in preferred stock, 2 million in total liabilities without preferred stock, and has a total stockholder’s equity of $2.3 million, the D/E ratio would be 1.30 if the preferred stock is included in total liabilities.
D/E = ($2,000,000 + $1,000,000)/ $2,300,000 = 1.30
However, if the preferred stock is included in stockholder’s equity, the D/E would be calculated as follows.
D/E = $2,000,000 /($2,300,000 + $1,000,000) = .61
Other accounts can be classified as debt as well and thus alter the debt-to-equity ratio, such as unearned income.
If a company is prepaid to do work, such as build an airplane for $50 million, until the plane is built, the $50 million is a liability.
Should this liability be included when calculating the debt-to-equity ratio, the numerator for the calculation would be $50 million higher.
Is There a Good Debt-To-Equity Ratio?
What is thought of as a good debt to equity ratio will vary depending on the type of business and the industry it is in.
Although, typically, if a company has a D/E ratio that is 2 or above, this would be thought of as risky.
Whereas a D/E ratio of less than 1 would be considered fairly safe.
There are industries that generally have higher D/E ratios than many other industries. In fact, a very low D/E ratio could be bad because it might mean the business is not using the debt financing it could be to grow.
What Does a Debt-To-Equity Ratio of 1 Indicate?
A debt-to-equity ratio of one would mean that the business with this ratio has one dollar of debt for each dollar of equity the business has.
For example, if a business has $1 million in assets and $500,000 in liabilities, it would have equity of $500,000.
Equity is calculated by subtracting liabilities from assets.
Then, dividing the debt of 500,000 by the equity of $500,000 gives a debt-to-equity ratio of 1.
What Does It Mean If the Debt-To-Equity Ratio Is Negative?
Businesses that have a negative D/E ratio have a negative shareholder’s equity.
This indicates that the business has fewer assets than it has liabilities.
This is generally considered to mean the business has a high level of risk and could even be at risk for bankruptcy.
In the previous example, if the business had $1.5 million in liabilities, the D/E ratio would be -3.
What Type of Industries Tend to Have High Debt-to-Equity Ratios?
For companies in the financial services sector, a reasonably high D/E ratio is not unusual.
Many banks have large debt loads due to the high amount of fixed assets they have, such as branch networks.
Capital-intensive industries also tend to have somewhat higher D/E ratios.
These are industries, such as automobile manufacturers or mining companies, that often use a large amount of debt financing.
How Can the Debt-to-Equity Ratio Be Used to Measure Risk?
A company with a high D/E ratio can find it more difficult to pay its current debts.
This can cause a company to have difficulty obtaining financing.
If the D/E is very high, it could mean a company has an increased likelihood of defaulting on its debts or possibly going bankrupt.
- The debt-to-equity ratio measures how leveraged a company is by measuring its total liabilities against total equity.
- A company with a high ratio indicates that the company is highly leveraged, which could pose a risk to shareholders. This is why it is often known as the risk ratio.
- The D/E ratio is of limited value when comparing companies in different industries, which often possess highly different ideal rates.
- Many investors use an altered version of the D/E ratio that uses only long-term debts because these often possess a highly different risk than short-term liabilities.
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Ohio University "Why the Debt-to-Equity Ratio Matters in Capital Structure" Page 1 . December 3, 2021
Michigan State University "Financial Ratios Part 6 of 21: Debt-To-Equity Ratio" Page 1 . December 3, 2021
Everett Community College "Financial Ratios " Page 2. December 3, 2021