Table of Contents
- How is the Debt-to-Equity (D/E) Ratio Calculated?
- What is the Debt-to-Equity (D/E) Ratio Used For?
- What is a Good Debt-to-Equity (D/E) Ratio?
a. Long-Term Debt-to-Equity (D/E) Ratio
b. Debt to Equity Swap
- Limitations to the Debt-to-Equity (D/E) Ratio
The Debt-to-Equity ratio, or D/E ratio, represents a company’s financial leverage, and measures how much a company is leveraged through debt, relative to its shareholders’ equity. The D/E ratio is a metric commonly to measure how much a company is leveraging through external versus internal financing.
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. The D/E ratio is also known as the company’s gearing or leverage.
How do you Calculate Debt-to-Equity (D/E) Ratio?
The D/E ratio is obtained by dividing the sum of the company’s debt by its total shareholders’ equity. It should be noted that the definition of debt may include other liabilities such as accounts payable, as these are amounts owed to other parties, similar to debt. In general, the calculation can be illustrated by the following formula:
For example, a company has $2 million in assets and $1 million in debt. To obtain the company’s equity figure, $1 million is subtracted from the $2 million in assets, as this figure includes assets funded by both debt and equity. This gives an equity figure of $1 million and a D/E ratio of 1.0, which is derived by dividing the total debt of $1 million by the equity figure of $1 million.
Read also: What is Loan-To-Cost (LTC) Ratio?
What is the Debt-to-Equity (D/E) Ratio Used For?
The D/E 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 D/E 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. The personal equity figure 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 personal financial risk through existing leverage.
Read also: Understanding Investment Properties
What is a Good Debt-to-Equity (D/E) Ratio?
While the definition of a good D/E ratio varies by industry, geography, company size, and other factors, in general a D/E ratio of between 0 and 1.0 is seen as healthy, and a D/E ratio of above 2.0 is seen as high.
For example, the banking industry typically tends to operate with a higher proportion of debt relative to equity. Therefore, a D/E Ratio of more than 1.0 is common, indicating that the company’s total liabilities exceeds their total shareholder equity, however this may not necessarily mean that the company is struggling to meet financial obligations.
In the technology industry, whose operations are typically not capital-intensive, the normal range for a D/E ratio is lower, and averages around 0.5. This means that the company’s total liabilities amounts to half of its total shareholder equity. In such an industry where a low D/E Ratio is the norm, the benchmark for what is considered a high D/E Ratio is also lower.
A Debt-to-Equity Ratio may also be negative if a company has negative shareholder equity, where a company’s liabilities are more than its assets. This is seen as very risky and may indicate that the company may be approaching bankruptcy.
Long-Term Debt-to-Equity (D/E) Ratio
The Long-term D/E ratio measures the proportion of a company’s long-term debt relative to its shareholders’ equity. Long-term debt is commonly defined as debt that is due to be repaid after twelve months or more.
The Long-term D/E ratio is not as commonly used as the D/E ratio, as it does not provide a comprehensive view of all liabilities a company is due to pay. It tends to be used in conjunction with the D/E ratio to obtain a view on how much of a company’s liabilities are long-dated as opposed to due within a year.
Debt to Equity Swap
In a Debt to Equity Swap, a company’s debt is offset in exchange for equity in the company. This allows the company to write off debts owed to lenders and is typically carried out in the event of a company’s imminent bankruptcy, or if they are unable to meet their debt repayments.
The net result of a Debt to Equity Swap is that the D/E ratio is lowered as the total amount of liabilities outstanding has decreased, and the amount of shareholder’s equity has increased.
Limitations to the Debt-to-Equity (D/E) Ratio
Firstly, the D/E ratio cannot be used as a benchmark across all industries and companies, as the levels for what is perceived as a low or high D/E ratio varies across industries, geographies, and other factors.
Secondly, the term debt is used quite loosely and different analysts may classify different assets as debt or equity quite subjectively. Preferred stock for example may be categorised by some as equity, while a preferred dividend may be seen by others as debt, due to its value and limited liquidation rights. Such varying treatment of D/E ratios can significantly impact 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.
Companies can also manipulate their D/E ratio by controlling what is classified as debt or equity on their accounts. This affects the credibility of the D/E ratio as a measure of a company’s financial leverage, and investors should bear this in mind when only looking at the D/E ratio as a measure of a company’s financial health. The D/E ratio is a useful measure, however investors should use it in conjunction with other metrics and analysis in order to derive a holistic view of a company’s financial health and performance.
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Disclaimer: The information and/or documents contained in this article does not constitute financial advice and is meant for educational purposes. Please consult your financial advisor, accountant, and/or attorney before proceeding with any financial/real estate investments.