The debt-to-equity (D/E) ratio tells you how much debt a company uses to run its business. It shows the balance between borrowed money (debt) and the money invested by the company owners (equity).¹,²,⁴
A higher debt-to-equity ratio suggests that the company relies heavily on debt, which can be risky if it struggles to meet its debt obligations. This increased risk can make the company less attractive to investors.
Since a higher ratio can mean a company is using more debt to finance its growth, it can lead to higher returns during good economic times. However, it also increases the company’s risk in downturns.
On the other hand, a lower debt-to-equity ratio means that a company is less dependent on borrowing, which can make it more stable in tough times but might limit growth opportunities.
How to calculate debt-to-equity ratio
The debt-to-equity ratio is calculated by dividing a company’s total liabilities by its shareholders’ equity, which is the difference between what a company owes vs. what it owns. In other words, shareholders’ equity is everything left over after paying liabilities and debts.¹
Debt-to-equity ratio = total liabilities ÷ shareholders’ equity
Example 1:
- A company has $5 million in total debt and $2.5 million in shareholders’ equity.
- Debt-to-Equity Ratio = Total Debt / Shareholders’ Equity = $5,000,000 / $2,500,000 = 2:1
- This means that for every dollar of equity, the business owes $2 of debt.
Example 2:
- Another company has $750,000 in total debt and $1.5 million in shareholders’ equity.
- Debt-to-Equity Ratio = Total Debt / Shareholders’ Equity = $750,000 / $1,500,000 = 0.5:1
- This indicates that for every dollar of equity, the business owes $0.50 of debt.
Interpreting the debt-to-equity ratio
Understanding the debt-to-equity ratio is crucial for both investors and companies. It offers insights into a company’s financial leverage, indicating the extent to which it is financing its operations through debt rather than its own resources.
It can be applied to various scopes, including individual projects, entire companies, or even personal finances, providing a quick snapshot of leverage and risk.
By examining the debt-to-equity ratio, you can identify potential strengths and weaknesses in a company’s financial strategy.
Higher D/E ratio:¹,³,⁴
- May suggest that a company could be heavily reliant on debt and unable to meet those obligations, which could increase its risk of bankruptcy.
- A high D/E ratio may be a red flag to investors, lenders, partners, and vendors.
- However, it could also indicate an efficient use of capital (banks or manufacturing businesses may have higher D/E ratios because they’re in industries that are generally more stable).
Lower D/E ratio:¹,³,⁴
- Indicates a more conservative financing approach, with less reliance on borrowed funds.
- However, this could also indicate too much reliance on equity and may not signal a growing business.
In times of economic uncertainty, companies with high debt-to-equity ratios may find it harder to secure financing. This can impact their ability to invest in new projects or expand operations, potentially leading to slower growth. Conversely, companies with lower ratios may be better positioned to weather economic downturns and take advantage of new opportunities.
Typical D/E ratio ranges across industries
The debt-to-equity ratio impacts not only individual companies but also entire industries and economies. It influences lending rates, credit availability, and overall economic growth. For example, a sector with generally high debt-to-equity ratios may be considered riskier, potentially leading to higher interest rates for borrowing and more conservative investment strategies.
- Tech-based companies tend to have a ratio of 2 or below.⁴
- Large manufacturing businesses tend to have between 2 and 5.⁴
- Banking or finance-based businesses tend to see a ratio between 10 and 20.⁴
Investors see anything above a 5 or 6 D/E ratio as a red flag; however, higher ratios are common in stabler industries like banking and finance.
Debt-to-equity ratio in personal finance
In personal finance, understanding one’s debt-to-equity ratio can help in making informed decisions about borrowing and investing.
In this case, however, total liabilities refer to mortgages, car loans, and credit card debts. And instead of shareholders’ equity, we’ll use your net worth, which is the difference between what you own and what you owe.⁵
Example:
A person has $100,000 in total debt and $200,000 in net worth, their debt-to-equity ratio would be 0.5:1.
This relatively low ratio indicates a strong financial position with a manageable level of debt. By regularly monitoring this ratio, individuals can make better financial decisions, such as when to take on new debt or when to focus on paying down existing liabilities.
High personal debt-to-equity ratios can be a red flag, indicating potential financial distress. For instance, if a person’s debt exceeds their assets, it may be challenging to secure additional loans or credit, and they might face higher interest rates. On the other hand, a low ratio suggests a solid financial footing and could make it easier to obtain favorable loan terms.
Either way, knowing your personal D/E ratio can help you plan toward financial stability and growth, as you can better balance your debt with personal assets.