Table of Contents
- How is the Debt-to-Equity (D/E) Ratio Calculated?
- What is the Debt-to-Equity (D/E) Ratio Used For?
- Limitations to the Debt-to-Equity (D/E) Ratio
Debt-to-Equity Ratio, or D/E Ratio represents a company’s financial leverage. The D/E ratio formula measures how much of a company’s finances are leveraged through debt compared to its retained earnings. This represents the company’s financial risk by indicating how the shareholders’ equity can cover the company’s outstanding debt should a downturn occur.
The D/E Ratio is a type of gearing ratio, which is a group of financial ratios comparing a company’s equity to its borrowed funds or liabilities.
How do you Calculate Debt-to-Equity (D/E) Ratio?
The D/E ratio is obtained by dividing the sum of the company’s liabilities by its total shareholders’ equity.
A high D/E ratio means that a company holds higher risk than a company with a lower D/E ratio, since the company has a higher proportion of debt than equity. In general, a Debt-to-Equity ratio which is considered relatively safe typically falls below 1.0, and a D/E ratio of 2.0 and above are usually seen as more high-risk.
For example, take a company with $2 million in assets and $1 million dollars in debt.
The total assets of $2 million includes both liabilities and equity, so by subtracting the $1 million dollars in debt owed by the company, it would have $1 million of equity. By dividing the $1 million of debt by the $1 million of equity, the company would work out to have a D/E ratio of 1.0, which is seen as relatively safe.
However, this may not be an accurate indicator of whether the company is over-leveraging or not, since a company may be able to use debts to generate more financial growth than it would be able to without the additional financing, with a net growth overall. On the other hand, a company with a lower D/E ratio may also be unprofitable or experiencing a net loss if the debt financing and interest rates are higher than the increase in income it brings.
Read also: What is Loan-To-Cost (LTC) Ratio?
What is the Debt-to-Equity (D/E) Ratio Used For?
The Debt-to-Equity Ratio is typically used in corporate finance, to estimate the extent to which a company is taking on debt to leverage its assets.
However, the Debt-to-Equity Ratio may sometimes be applied to personal finance, where it is known as the Personal Debt-to-Equity Ratio. The Personal D/E Ratio is calculated by dividing an individual’s total personal liabilities by their personal equity, which can be obtained by subtracting liabilities from total personal assets. Similar to the D/E ratio for companies, the personal D/E ratio is also used to assess financial risk through existing leverage.
Read also: Understanding Investment Properties
Limitations to the Debt-to-Equity (D/E) Ratio
Firstly, a fixed D/E ratio cannot be used as a benchmark across all industries since some industries tend to have a higher or lower D/E ratio than others and may also be affected by a number of factors.
Secondly, the term debt is used quite loosely and different analysts may classify different assets as debt or equity quite subjectively. In the case of preferred stock, for example, which some analysts may categorise as equity, while a preferred dividend may be seen by others as debt, due to its value and limited liquidation rights.
Calculations of the D/E ratio which calculate preferred stock as part of the company’s equity may lower the ratio, which can significantly disadvantage companies such as Real Estate Investment Trusts (REITs), which tend to hold more preferred stock with a higher amount of debt used as leverage as part of their business model.
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