The debt-to-equity ratio (D/E) is a financial ratio that indicates the relative amount of a company's equity and debt used to finance its assets. This ratio is also known as financial leverage.
The debt-to-equity ratio is the most important financial ratio and is used as a standard for judging a company's financial strength. It is also a measure of a company's ability to repay its obligations. When examining the health of a company, it is critical to pay attention to the debt-to-equity ratio. If the ratio is rising, the company is being financed by creditors rather than from its own financial sources, which can be a dangerous trend. Lenders and investors usually prefer low debt-to-equity ratios because their interests are better protected in the event of a business decline. Therefore, companies with high debt-to-equity ratios may not be able to attract additional debt capital.
A debt-to-equity ratio is calculated by taking the total liabilities and dividing it by the shareholders' equity:
Debt-to-equity ratio = Liabilities / Equity
Both variables are shown on the balance sheet (statement of financial position). In the debt-to-equity ratio calculation, total liabilities refer to all of the company's outstanding debts and financial obligations. This includes both short-term and long-term liabilities, such as:
- Long-term debt, such as bonds and loans with a maturity of more than one year
- Short-term debt, such as bank loans and commercial paper with a maturity of less than one year
- Current liabilities, such as accounts payable, taxes owed, and other unpaid bills
- Contingent liabilities, such as potential lawsuits or other uncertain obligations
It is important to note that liabilities used in the debt-to-equity ratio calculation should be reported on the company's balance sheet. And the way of accounting for these liabilities may vary from company to company.
If equity is negative, it means that a company's liabilities exceed its assets, which is often referred to as "negative net worth" or "insolvency". In this situation, the debt-to-equity ratio would not be meaningful because the denominator (equity) is negative. A negative debt-to-equity ratio would also not be meaningful because it would indicate that the company has more debt than equity, which is not possible.
However, it is important to note that sometimes companies have negative equity but are still operating and generating revenue. In this case, the debt-to-equity ratio would not be a good indicator of the company's financial condition.
Norms and Limits
The optimal debt-equity ratio is considered to be around 1, i.e. liabilities = equity, but the ratio is very industry-specific because it depends on the ratio of current to non-current assets. The more non-current the assets (as in capital-intensive industries), the more equity is required to finance these long-term investments.
For most companies, the maximum acceptable debt-to-equity ratio is 1.5-2 and less. For large public companies, the debt-to-equity ratio can be much higher than 2, but it is not acceptable for most small and medium-sized companies. For US companies, the average debt-to-equity ratio is about 1.5 (this is also typical for other countries).
In general, a high debt-to-equity ratio indicates that a company may not be able to generate enough cash to meet its debt obligations. However, a low debt-to-equity ratio can also indicate that a company is not taking advantage of the increased profits that financial leverage can bring.
A low debt-to-equity ratio does not necessarily indicate that a company is not taking advantage of the increased profits that financial leverage can bring. A low debt-to-equity ratio can indicate that a company is in a strong financial position and has less financial risk, and it may be generating profits through other means such as strong sales or efficient operations.
However, it is important to note that financial leverage can increase a company's profits by allowing it to invest in growth opportunities with borrowed money. So, a company with low debt-to-equity ratio may be missing out on the potential to increase profits through financial leverage.
It is also worth noting that, some industries or sectors like utilities or regulated industries have a lower risk and thus have a lower debt-to-equity ratio. But that doesn't mean they are not taking advantage of the leverage, it just means that the leverage is not suitable for them and they have other ways to generate profits.
It is important to keep in mind that the debt-to-equity ratio is just one of many financial metrics that can be used to evaluate a company's financial health, and it should be considered in the context of the company's overall financial situation and industry. It's important to analyse the company's financial statements, cash flows and other ratios to understand the company's financial situation.
Exact Formula in the ReadyRatios Analysis Software
Debt-to-equity ratio = F1[Liabilities] / F1[Equity]
F1 – Statement of financial position (IFRS)
The debt-to-equity ratio is an important indicator of the financial health of a company, particularly for fast-growing companies. This ratio helps to understand how much debt a company has compared to its equity and assesses the risk associated with rapid business development. It is especially relevant for startups, as they often rely heavily on debt financing to support their growth.
Financial Ratios Similar to the Debt-to-Equity Ratio
Interest Coverage Ratio: This ratio measures a company's ability to meet its interest payments on its debt. It is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expense. A low interest coverage ratio indicates that a company may have difficulty meeting its debt obligations.
Times Interest Earned Ratio: This ratio is calculated by dividing a company's EBIT by its annual interest expense. It indicates a company's ability to cover its interest expense with its operating income.
Current Ratio: This ratio measures a company's ability to meet its short-term obligations by comparing its current assets to its current liabilities. It is calculated by dividing current assets by current liabilities. A current ratio of less than 1 indicates that a company may have difficulty meeting its short-term obligations.
All these ratios are complementary, and their use and interpretation should consider the context of the company and the industry it operates in.