What Is Debt To Equity Ratio (D/E Ratio)?
The Debt to Equity Ratio is a financial leverage ratio, that calculates the total weight of a company’s total liabilities against the shareholders’ equity. The debt to equity ratio signifies, in a business dwindling scenario, to what extend shareholders’ equity can fulfill the obligation to its creditors.
D/E ratio is an important ratio to evaluate a business’s financial leverage and to know how many operations of the company running on debt and how much on its own money.
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Formula and Calculation of Debt To Equity Ratio
The Debt to equity ratio can be calculated by dividing a company’s total liabilities (Short-term debt + long-term debt + other fixed payments) by the shareholders’ equity.
Debt To Equity Ratio = Total liabilities/Shareholders’ equity
The total liabilities and shareholders’ equity can be found on the balance sheet of the company.
Suppose a company has total liabilities of $500 million and shareholders’ equity of the company is $250 million, then what will be the company’s debt to equity ratio (D/E Ratio).
Debt To Equity Ratio (D/E) = $500 million/$250 million = 2
This result means the company has $2 debt on every $1 of equity. The ratio obviously does not give a clear picture to the company’s investors, they need to compare it with similar companies from the same industry (Peer comparison).
Preferred Debt To Equity Ratio
The optimal D/E ratio changes with the industry, but generally it should not be higher than 2. In some higher fixed asset-intensive industry it may be higher, but that should not be a concern if the company is a profitable one.
A 2 D/E ratio means the company is operating on two third debt and one-third shareholders’ equity. So, this means the company borrowed twice as much as its own capital.
High D/E Ratio Vs Low D/E Ratio
A company with a high D/E ratio does not necessarily mean a bad one, as D/E varies with industry. Some times a high D/E may be a good thing for a profitable company as, the firm can manage high debt obligation and increase the return in equity using the leverage.
For example, in the case of two company with the same profit, but with different debt, the company with higher debt have a higher return on equity (ROE). And usually debt cost is lower than the cost of equity.
On the other side company with a lower D/E ratio may be ignoring the growth opportunity or have plenty of cash in hand. One of the important benefits of lower D/E is the interest cost if a company is not earning well, or economy is going through a recession, then a company with lower D/E have a better chance of survival in the market with a lower chance of bankruptcy.
Why D/E Ratio Matters
The debt to equity ratio is an important factor while analyzing a company or an industry. D/E ratio tells investors, where a company is standing financially. D/E ratio combined with the price-earnings ratio (P/E ratio), ROE, and P/B ratio gives a better idea about the company and help to calculate its future growth.
A company could generate higher earnings by analyzing its debt and if higher leverage increases earnings higher than the interest cost, then shareholders should expect to benefit and investors use D/E ratio to analyze this.
The Bottom Line
There are many way investors use debt to equity ratio and it is a very important ratio for long term investor, who gives weightage to the fundamentals of a company. Similarly, like other ratio debt to equity ratio have several limitations, as it works well on a company operating in a similar industry. So overall it’s a great tool and helps value investors to pick the right stocks.