Debt-to-Equity Ratio: calculation, benchmark

Petersen Trading Company has total liabilities of $937,500 and a debt to equity ratio of 1.25. Debt to equity ratio is calculated by dividing total liabilities by stockholder’s equity. The D/E ratio can be classified as a leverage ratio (or gearing ratio) that shows the relative amount of debt a company has. As such, it is also a type of solvency ratio, which estimates how well a company can service its long-term debts and other obligations. This is in contrast to a liquidity ratio, which considers the ability to meet short-term obligations. A company's management will, therefore, try to aim for a debt load that is compatible with a favorable D/E ratio in order to function without worrying about defaulting on its bonds or loans.

The debt-to-equity (D/E) ratio is a calculation of a company’s total liabilities and shareholder equity that evaluates its reliance on debt. It’s a measure showing the percentage of a company’s assets financed by long-term debt. A lower ratio suggests a healthier financial position with less reliance on debt. When we talk about a company’s debt-to-asset ratio, it can be shown either as a decimal number or a percentage. To better understand a company’s financial stability, it’s recommended to compare the ratio over several periods.

Debt-To-Equity Ratio: What it is and How to Calculate it

The benefit of debt capital is that it allows businesses to leverage a small amount of money into a much larger sum and repay it over time. This allows businesses to fund expansion projects more quickly than might otherwise be possible, theoretically increasing profits at an accelerated rate. For individuals, it compares total personal debts to total assets minus debts (net worth).

A lower ratio reflects better financial stability and less risk of insolvency. The debt-to-asset ratio is a vital metric in finance that provides clarity on financial health. Check out our blog for more in-depth information on personal finance and more. If your debt-to-asset ratio is high and the other conditions mean the number is not ideal, improving it is necessary for any potential investment.

The debt to equity ratio is considered a balance sheet ratio because all of the elements are reported on the balance sheet. Conversely, a low D/E ratio suggests that a company has ample shareholders’ equity, reducing the need to rely on debt for its operational needs. This indicates that the company is primarily financed through its own resources, reflecting strong financial stability and a lower risk profile. The debt-to-equity (D/E) ratio can help investors identify highly leveraged companies that may pose risks during business downturns.

What is Economic Profit? Understanding True Business Performance Beyond Accounting Numbers

When analyzed together, they offer a more well-rounded view of a company’s financial standing. A company with a high D/E ratio may find it challenging to secure additional funding, as lenders and investors might what is cost accounting view it as a risky venture. On the other hand, a certain level of debt can be beneficial as it allows companies to leverage borrowed funds for expansion and growth, potentially leading to higher returns for shareholders. This ratio is significant as it gives a snapshot of the company’s capital structure and how it finances its operations and growth. A lower D/E ratio usually implies a more financially stable business, while a higher ratio may indicate potential financial risk.

Conclusion: Navigating Financial Health with the D/E Ratio

• The underlying principle generally assumes that some leverage is good, but too much places an organization at risk.
• Yes, every industry has different standards due to operating models and capital needs.
• For comparison of two or more companies, analyst should obtain the ratio of only those companies whose business models are the same and that directly compete with each other within the industry.
• Before investing, you should consider your tolerance for these risks and your overall investment objectives.

Do not infer or assume that any securities, sectors or markets described in this article were or will be profitable. Historical or hypothetical performance results are presented for illustrative purposes only. This range often reflects a balanced approach to financing, where a company may be using both equity and debt to support its operations. For some well-established firms, a ratio in this range may indicate flexibility in funding strategies while still maintaining manageable debt levels. Both IFRS and GAAP require that retained earnings be included in the denominator of the debt-to-equity ratio.

Company B: Tesla, Inc. (As of

• To illustrate how these ratios work in practice, let’s analyze 10 leading Indian companies.
• For most companies, the maximum acceptable debt-to-equity ratio is 1.5-2 and less.
• When interpreting the D/E ratio, you always need to put it in context by examining the ratios of competitors and assessing a company's cash flow trends.
• The cost of debt and a company’s ability to service it can vary with market conditions.

However, if that cash flow were to falter, Restoration Hardware may struggle to pay its debt. Total liabilities are all of the debts the company owes to any outside entity. On the other hand, a comparatively low D/E ratio may indicate what is a purchase order and how does it work that the company is not taking full advantage of the growth that can be accessed via debt.

Note that, as stated in the image, this scenario is a bit unrealistic because the company’s Interest Rate on Debt would almost certainly change if it went from 20% to 50% Debt / Total Capital. In other words, if a company’s Debt / Equity is on the high side, that doesn’t necessarily matter if the company still has a reasonable Debt / EBITDA and EBITDA / Interest. Lenders also look at metrics like the Leverage Ratio (Debt / EBITDA), Interest Coverage Ratio (EBITDA / Interest), Liquidity Ratio, and many others to judge a company. While it’s tempting to say that “lower is better” and “higher is worse” with this ratio, that’s not quite how it works.

Why Some Highly Leveraged Companies Still Perform Well

Debt due sooner shouldn't be a concern if we assume that the company won't default over the next year. A company's ability to service long-term debt will depend on its long-term business prospects, which are less certain. The Current Ratio includes all current assets, while the Quick Ratio excludes inventory, offering a stricter measure of short-term liquidity. Such information is time sensitive and subject to change based on market conditions and other factors.

Banks carry higher amounts of debt because they own substantial fixed assets in the form of branch networks. Higher D/E ratios can also be found in capital-intensive sectors that are heavily reliant on debt financing, such as airlines and industrials. A company has negative shareholder equity if it has long-term liabilities examples with detailed explanation a negative D/E ratio, because its liabilities exceed its assets.

What does a negative D/E ratio mean?

The growing reliance on debt could eventually lead to difficulties in servicing the company’s current loan obligations. Very high D/E ratios may eventually result in a loan default or bankruptcy. The typically steady preferred dividend, par value, and liquidation rights make preferred shares look more like debt. Business owners use a variety of software to track D/E ratios and other financial metrics. For example, Microsoft Excel provides a balance sheet template that automatically calculates financial ratios such as the D/E ratio and the debt ratio. It indicates the proportion of an individual’s assets funded by debt.

For instance, utility companies often exhibit high D/E ratios due to their capital-intensive nature and steady income streams. These companies frequently borrow extensively, given their stable returns, making high leverage ratios a common and efficient use of capital in this slow-growth sector. Similarly, companies in the consumer staples industry tend to show higher D/E ratios for comparable reasons.

While it depends on the industry, a D/E ratio below 1 is often seen as favorable. Ratios above 2 could signal that the company is heavily leveraged and might be at risk in economic downturns. A challenge in using the D/E ratio is the inconsistency in how analysts define debt. Let’s examine a hypothetical company’s balance sheet to illustrate this calculation. In the majority of cases, a negative D/E ratio is considered a risky sign, and the company might be at risk of bankruptcy. However, it could also mean the company issued shareholders significant dividends.

A significantly low ratio may, however, also be found in companies that reluctant to take the advantage of debt financing for growth. Debt to equity ratio (also termed as debt equity ratio) is a long term solvency ratio that indicates the soundness of long-term financial policies of a company. It shows the relation between the portion of assets financed by creditors and the portion of assets financed by stockholders.

A company with a D/E ratio that exceeds its industry average might be unappealing to lenders or investors turned off by the risk. As well, companies with D/E ratios lower than their industry average might be seen as favorable to lenders and investors. A debt to equity ratio of 1.5 indicates that a company has 1.5 times more debt than equity. This suggests higher financial risk as a larger proportion of the company's financing comes from debt. The meaning of such a ratio is heavily dependent on industry averages for similar companies.