What is Debt to Equity Ratio and Why You Should Know About It?

As an investor, it can sometimes feel like your job is never fully done. There are just so many things to consider. You are scanning for the right stocks, understanding market sentiment, evaluating risk profiles, and aligning everything with your financial goals and evolving needs. Amid all of this, you also need to dig into some of the deeper numbers that tell you how a company is really doing, like the debt-to-equity ratio.

If you are investing in stocks, metrics such as the debt-to-equity ratio can help you better understand a company. While you can always work with a financial advisor to get a more detailed analysis of this metric, understanding the basics yourself can give you a better footing to make informed decisions.

This article will break down what a company’s debt-to-equity ratio is, how it is calculated, and why it is important for investors like you.

Debt to equity ratio – Definition

The debt-to-equity ratio is a financial metric that measures a company’s reliance on debt relative to shareholders’ equity. All companies need money to fund their operations, and sometimes that money comes from debt. Companies may take loans to keep running. They also run on shareholder money when investors buy stocks. The debt-to-equity ratio gives you an idea of the company’s financial structure and how it handles the money it borrows and the money invested by its owners.

Depending on the context, this calculation can use either book values or market values. Regardless of the approach, the ratio helps you understand the overall risk a company carries based on how much it borrows to finance its business.

The debt-to-equity ratio can also give you a sense of how expensive it might be for a company to issue additional debt. If a company is already heavily burdened with debt, lenders may view it as a higher risk and charge higher interest rates. This further increases the cost of future borrowing.

Conversely, a company with a low debt-to-equity ratio can borrow more easily and at a lower cost. This gives it more flexibility to invest in new projects.

How can you calculate a company’s debt-to-equity ratio?

Calculating the debt-to-equity ratio is actually quite simple. Everything you need is available on a company’s balance sheet. You take a company’s total debt and divide it by its common shareholders’ equity. It is important to note that you use common shareholders’ equity, not total equity, because this gives a clearer picture of what belongs to equity investors. The formula looks like this:

Debt to equity ratio = Total debt/ Common shareholders’ equity

Here is an example that can help you understand this better:

Suppose a company has total debt of $10 million and common shareholders’ equity of $80 million.

Using the formula:

Debt to equity ratio = $10 million/$80 million = 0.125

Hence, the company’s debt-to-equity ratio is 0.125. This implies that for every dollar of equity invested in the business, the company has about 12.5 cents of debt. That indicates relatively low leverage and suggests the company is not heavily reliant on borrowing.

So, let’s say you calculate a company’s debt-to-equity ratio. How do you then use it? Let’s break it down:

A company with a high debt-to-equity ratio is relying more heavily on borrowed money. Now, this can be seen as high risk because a company with high debt would have mandatory interest payment obligations.

When a company has a higher debt-to-equity ratio, it essentially has the four types of debt. The first two are short-term and long-term loans from banks or financial institutions. The other two are accounts payable and accrued expenses. While the loan part is more or less self-explanatory, accounts payable refers to when a company purchases goods or services on credit rather than paying immediately. Accrued expenses are costs a company has already incurred but has not yet paid or received an invoice for.

If a company has too much of any of these debts, a larger portion of its cash flow would go toward paying interest and principal. This would leave less money available for growth or rewarding shareholders through dividends.

On the other hand, a company with a low debt-to-equity ratio used equity financing and not debt. This generally indicates less risk because the company has fewer mandatory obligations and a greater chance of using profits to benefit shareholders over time. Companies with a lower equity-to-debt ratio are more likely to grow. This, in turn, improves the chances of receiving dividends. A sure win for investors!

It is especially important to consider the debt-to-equity ratio because common shareholders are last in line in the event of liquidation. Bondholders and other debt holders get paid first, and only after those obligations are met do shareholders get any leftover profits. Hence, understanding the debt-to-equity ratio helps you evaluate risk and reward. It gives you a clearer picture not only of how a company finances itself but also of its potential for shareholders.

What is a good debt-to-equity ratio?

When you first look at the debt-to-equity ratio, you may draw the obvious conclusion – a lower number is always good and a higher one is always bad. In reality, it is not that simple.

A good starting point is comparison. Generally, it is best if a company’s debt-to-equity ratio is close to that of its peer companies. Businesses within the same industry tend to have similar capital and borrowing needs. So, make sure that you compare companies from the same industry. For example, two companies from the pharmaceutical industry, and not one from the pharmaceutical and the other from consumer goods.

The ideal debt-to-equity ratio can vary widely by industry. That said, there is a broad rule of thumb many investors use. A debt-to-equity ratio above 2 is often considered a good debt-to-equity ratio. A ratio of 2 implies that the company is using twice as much debt as equity to finance its operations.

Companies with a debt-to-equity ratio above 2 may carry greater risk due to a higher reliance on debt.  A lower or moderate debt-to-equity ratio, on the other hand, may indicate a healthier balance between debt and equity and suggest the company is not overly dependent on borrowing.

As an investor, your goal is not to find a good debt-to-equity ratio for a company and its industry. You can do this by comparing the ratio to industry benchmarks and to the company’s overall financial position. Or, you can simply hire a financial advisor and let them find out whether the companies you are interested in have a good debt-to-equity ratio or not.

Why is the debt-to-equity ratio important for investors?

The debt-to-equity ratio is important because it shows how a company funds its operations and the financial risk it carries.

When you invest in a company, you take on its risk. When a company has a high debt-to-equity ratio, it is pretty heavily dependent on borrowed money to run its operations. In simple terms, the business is using more external funding than it is investing from shareholders’ capital. This can be problematic for you, as it may indicate that the company’s earnings are being spent on clearing loans rather than generating returns for you.

That said, a high debt-to-equity ratio does not automatically indicate that something is wrong. In some cases, it can mean the company is earning enough to meet its debt obligations without any hassles. In fact, if the business generates stable, predictable cash flows, debt can be used as a strategic tool for growth. Some companies may even use debt to lower the Weighted Average Cost of Capital (WACC).

WACC is the average cost a company pays to finance its assets through both debt and equity. Debt is often cheaper than equity, especially when interest rates are low. Hence, by increasing debt, a company can reduce its overall cost of capital, thereby improving profitability if managed well.

Debt can also amplify returns. When used wisely, borrowing allows a company to invest more capital into its business than it could using equity alone. In such situations, a higher debt-to-equity ratio may actually work in your favor.

However, companies with higher debt-to-equity ratios are more likely to default on their credit. If a company earns less or spends more, it would struggle to meet its interest and principal payments. A series of missed debt payments can hurt the company’s credit rating and overall market reputation. Lenders may become reluctant to offer further loans as well. Or, even worse, they may charge higher interest rates due to the increased risk. This added cost can reduce profits and often leads to a decline in the company’s share price.

In extreme cases, it can also lead to bankruptcy. From an investor’s perspective, this risk is critical. Equity shareholders are last in line during liquidation, so excessive debt increases the chances of losing capital if things go wrong. This is why companies with low-to-moderate debt-to-equity ratios often attract more investor attention.

It is important for investors to look at the past trend of the debt-to-equity ratio, and not just the current number. Comparing the debt-to-equity ratio with previous financial years can tell you a lot. An increasing ratio does not always mean trouble. It may indicate that the company is raising funds aggressively to expand operations.

That said, there are clear downsides when the debt-to-equity ratio becomes too high. A company with excessive debt may struggle to repay its obligations during periods of loss. High debt often goes hand in hand with low liquidity. In such situations, lenders usually charge higher-than-normal interest rates, further increasing the cost of borrowing. As interest expenses rise, a larger portion of profits gets consumed by debt repayments. This leaves very little for shareholders in the form of dividends, resulting in lower returns.

The debt-to-equity ratio is also closely linked to the cost of equity. As leverage increases, equity becomes riskier. When investors perceive higher risk, they demand higher returns. Remember, the whole high-risk brings the potential for higher rewards? It is exactly that! This increases the cost of equity, potentially raising the company’s WACC. A higher WACC generally leads to a lower valuation, putting pressure on the share price to decline.

Use the debt-to-equity ratio to make smarter investment decisions

The debt-to-equity ratio may seem like a technical figure that you do not need to know. But it can guide your investment decisions to a great extent. It gives you an idea of how a company raises funding and the financial risks it carries.

While calculating the ratio might seem complex at first, it really is not. All you need is a simple formula and a few numbers readily available on a company’s balance sheet. And, you can calculate it yourself and use it to compare companies.

You can also consider working with a financial advisor to make things even easier. A financial advisor can help you calculate and interpret the ratio. If you are looking for professional guidance, our financial advisor directory can help you find a qualified financial advisor near you.

Frequently Asked Questions (FAQs) about the debt-to-equity ratio

1. Can the debt-to-equity ratio be negative?

Yes, it can. A negative debt-to-equity ratio occurs when a company’s total liabilities exceed its total assets. Investing in a company with a negative debt-to-equity ratio can entail high risk.

Companies with a negative debt-to-equity ratio may have ongoing losses and poor financial health. They may also be headed to bankruptcy. It is important to speak with a financial advisor if you are investing in a company with a negative debt-to-equity ratio.

2. Does the debt-to-equity ratio differ across industries?

Yes, the debt-to-equity ratio varies significantly across industries. Some sectors naturally operate with higher levels of debt due to the nature of their businesses. For example, banks and financial services companies typically have higher debt-to-equity ratios. Industries like airlines and industrials also tend to carry higher debt levels.

On the other hand, oil and gas companies often maintain relatively lower debt-to-equity ratios.

It is important to compare a company’s debt-to-equity ratio with those of peers in the same industry, rather than with unrelated sectors, to get a clear view of the company’s financial health.

3. Should you invest in a company with a higher or lower debt-to-equity ratio?

In general, a lower debt-to-equity ratio is often preferred because it suggests the company carries less debt on its balance sheet. Lower debt usually means lower financial risk. However, this is not a universal rule. The right debt-to-equity ratio depends on the company’s industry and growth stage. Younger or fast-growing companies often take on more debt. In such cases, a higher debt-to-equity ratio may not be such a big, bad thing.

As an investor, you should always view the debt-to-equity ratio alongside other factors, such as the industry, the company’s past performance, and age. It is also advised to get a financial advisor’s opinion on the topic.