What Is a Debt-to-Equity Ratio and How Do Investors Interpret the Number?

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Because banks borrow funds to loan money to consumers, financial institutions usually have higher debt-to-equity ratios than other industries. In the banking and financial services sector, a relatively high D/E ratio is commonplace. Banks carry higher amounts of debt because they own substantial fixed assets in the form of branch networks. Higher D/E ratios can also tend to predominate in other capital-intensive sectors heavily reliant on debt financing, such as airlines and industrials. We can see below that for Q1 2024, ending Dec. 30, 2023, Apple had total liabilities of $279 billion and total shareholders’ equity of $74 billion. However, a TIE ratio that is extremely high (e.g., above 10) might indicate that the company is under-leveraged and potentially missing growth opportunities by not utilizing debt financing optimally.

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What is the Debt to Equity Ratio Formula?

  • The debt/equity ratio, also known as the financial leverage ratio or D/E ratio, is a financial metric that measures the proportion of a company’s total debt to its shareholders’ equity.
  • Industry analysts typically examine 3-5 year trends to distinguish between short-term fluctuations and fundamental changes in debt servicing capability.
  • This number represents the residual interest in the company’s assets after deducting liabilities.
  • The numerator in above formula consists of total current and long-term liabilities and the denominator consists of total stockholders’ equity, including preferred stock, if any.
  • The lender of the loan requests you to compute the debt to equity ratio as a part of long-term solvency test of the company.

Each industry has different debt to equity ratio benchmarks, as some industries tend to use more debt financing than others. A debt ratio of .5 means that there are half as many liabilities than there is equity. In other words, the assets of the company are funded 2-to-1 by investors to creditors.

Debt to Equity Ratio

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This historical perspective is crucial for identifying companies with consistently strong financial health versus those experiencing temporary improvements. Industry analysts typically examine 3-5 year trends to distinguish between short-term fluctuations and fundamental changes in debt servicing capability. InvestingPro’s advanced stock screener lets you filter companies by Interest Coverage Ratio to identify financially resilient businesses. However, it is crucial to compare the D/E ratio with peers drop shipping and sales tax in the same industry and consider the company’s specific circumstances for a more insightful analysis.

Real-World Example: Comparing Debt/Equity Ratios in the Technology Industry

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. The depository industry (banks and lenders) may have high debt-to-equity ratios.

While this TIE might seem low by general standards, it’s typical for utilities due to their capital-intensive nature and stable regulated revenues. Investors would compare this to industry peers rather than applying general home office deductions benchmarks. Industry benchmarks should serve as starting points rather than absolute standards when evaluating a specific company’s TIE ratio.

  • The recent debt-to-equity conversion in 2023 resulted in the government acquiring a 33 per cent stake, causing valuation loss based on prevailing share price.
  • A company’s total debt is the sum of short-term debt, long-term debt, and other fixed payment obligations (such as capital leases) of a business that are incurred while under normal operating cycles.
  • A company with a ratio this high will almost certainly have to pay a premium to issue Debt in the future based on the YTM of bond issuances.
  • Vodafone Idea has cleared that the promoters—Aditya Birla Group and Vodafone Plc—will continue to have operational control of the firm, however, the government’s stake will be higher now.
  • However, if the additional cost of debt financing outweighs the additional income that it generates, then the share price may drop.
  • A ratio around 1 suggests a balanced capital structure, while a ratio above 1 may signal higher financial risk due to greater reliance on debt.

This number can tell you a lot about a company’s financial health and how it’s managing its money. Whether you’re an investor deciding where to put your money or a business owner trying to improve your operations, this number is crucial. Including preferred stock in total debt will increase the D/E ratio and make a company look riskier. Including preferred stock in the equity portion of the D/E ratio will increase the denominator and lower the ratio.

How to Interpret D/E Ratio?

Another benefit is that typically the cost of debt is lower than the cost of equity, and therefore increasing the D/E ratio (up to a certain point) can lower a firm’s weighted average cost of capital (WACC). 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. Publicly traded companies that are in the midst of repurchasing stock may also want to control their debt-to-equity ratio. That’s because share buybacks are usually counted as risk, since they reduce the value of stockholder equity.

A higher ratio may deter conservative investors, while those with a higher risk tolerance might see it as an opportunity for greater returns. Ultimately, the D/E ratio tells us about the company’s approach to balancing risk and reward. A company with a high ratio is taking on more risk for potentially higher rewards. In contrast, a company with a low ratio is more conservative, which might be more suitable for its industry or stage of development. Considering the company’s context and specific circumstances when interpreting this ratio is essential, which brings us to the next question. A higher ratio suggests that the company uses more borrowed money, which comes with interest and repayment obligations.

Debt-to-Equity Ratio FAQs

Wise use of debt can help companies build a good reputation with creditors, which, in turn, will allow them to borrow more money for potential future growth. •   The D/E ratio is just one of many indicators investors should consider, as it should be contextualized within industry standards and accompanied by a broader analysis of a company’s financial health. If a company has a negative D/E ratio, this means that it has negative shareholder equity. In most cases, this would be considered a sign of high risk and an incentive to seek bankruptcy protection.

What Does the D/E Ratio Tell You?

Inflation can erode the real value of debt, potentially making a company appear less leveraged than it actually is. This ratio compares a company’s equity to its assets, showing how much of the company’s assets are funded by equity. Ultimately, businesses must strike an appropriate balance within their industry between financing with debt and financing with equity. In order to calculate the debt-to-equity ratio, you need to understand both components. •   Different industries have varying acceptable D/E ratios, with capital-intensive sectors often operating with higher ratios due to their borrowing needs for growth. InvestingPro provides historical financial data that allows you to track Interest Coverage Ratio trends over multiple quarters and years.

Debt to Equity Ratio – What is it?

It suggests that a company relies heavily on borrowing to fund its operations, often due to insufficient internal finances. Essentially, the company is leveraging debt financing because its available capital is inadequate. It is crucial to consider the industry norms and the company’s financial strategy when assessing whether or not a D/E ratio is good. Additionally, the ratio should be analyzed with other financial metrics and qualitative factors to get a comprehensive view of the company’s financial health. The D/E ratio is a powerful indicator of a company’s financial stability and risk profile.