What Is Debt-to-Equity Ratio?

What Is Debt-to-Equity Ratio?

 

The debt-to-equity (D/E) ratio, which measures a company's financial performance, is determined by dividing its total liabilities by the value of its equity holders. The D/E ratio is a crucial indicator in corporate finance. It determines how much debt a business is using to fund operations as opposed to using cash on hand.

 

How to calculate Debt-to-Equity Ratio?

 

The information needed to compute the D/E ratio can be found on the balance sheet of a publicly listed company. Subtracting the value of liabilities from total assets on the balance sheet yields the figure for shareholder equity, which is a rearranged form of the balance sheet equation:

Assets=Liabilities + Shareholder Equity

These balance sheet categories may include items that are not generally considered debt or equity in the traditional sense of a loan or an asset. Because the ratio can be affected by retained earnings or losses, intangible assets, and pension plan adjustments, additional research is usually required to determine how heavily a company relies on debt.

Analysts and investors frequently change the D/E ratio to acquire a clearer picture and make comparisons easier. They also consider the D/E ratio in relation to short-term leverage ratios, profitability, and growth projections.

 

D/E Ratio Limitations

 

When calculating the D/E ratio, it is critical to consider the industry in which the company operates. Because different businesses have varying capital requirements and growth rates, a common D/E ratio value in one area may be a red flag in another.

Utility stocks frequently have extremely high D/E ratios. Utilities borrow significantly and relatively inexpensively because they are a highly regulated industry that makes large investments at a stable rate of return and generates a consistent income stream. In slow-growth businesses with consistent income, high leverage ratios imply an efficient use of capital. For similar reasons, companies in the consumer staples sector have high D/E ratios.

Analysts are not always uniform in their definition of debt. Preferred stock, for example, is sometimes considered equity because preferred dividend payments are not legal obligations and preferred shares rank lower than all debt (but higher than common stock) in terms of priority of claim on corporate assets. However, the normally consistent preferred dividend, par value, and liquidation rights make preferred shares appear more like debt.

Incorporating preferred stock into total debt raises the D/E ratio and makes a company appear riskier. Including preferred stock in the equity element of the D/E ratio raises the denominator while decreasing the ratio. This is a particularly difficult topic to address when studying companies that rely heavily on preferred stock funding, such as real estate investment trusts.

FAQ

What is an ideal debt-to-equity (D/E) ratio?

 

What constitutes a "good" debt-to-equity (D/E) ratio is determined by the nature of the company and its industry. A D/E ratio of less than one would be considered quite safe, however values of two or more would be considered dangerous. Utilities, consumer staples, and banking are examples of industries with relatively high D/E ratios. It should be noted that a particularly low D/E ratio may be a negative indicator, implying that the company is not taking use of debt financing and its tax benefits.

 

Debt-to-Equity ratio of 1.5 indicates what?

 

A D/E ratio of 1.5 indicates that the corporation has rupee 1.50 in debt for every rupee 1 in equity. Assume the corporation has 2 crore in assets and 1.2 crore in liabilities. The company's equity would be 80 Lacs because equity equals assets minus liabilities. As a result, the D/E ratio would be 1.2 crore divided by 80 Lacs or 1.5.

 

A negative D/E ratio indicates what?

 

A negative D/E ratio indicates that a corporation has negative shareholder equity. To put it another way, the company's liabilities surpass its assets. In most circumstances, this would be regarded as an indication of high risk and an urge to file for bankruptcy.

 

Which industries have the highest D/E ratios?

 

A significantly high D/E ratio is frequent in the banking and financial services sector. Banks have more debt since they own significant fixed assets in the form of branch networks. Higher D/E ratios can also be found in other capital-intensive industries that rely substantially on debt financing, such as airlines and industrials.

 

How may the D/E ratio be used to assess the risk level of a company?

 

A rising D/E ratio may make it more difficult for a corporation to get funding in the future. The company's increasing reliance on debt may eventually make it harder to service its present loan obligations. Extremely high D/E ratios may eventually lead to loan default or bankruptcy.