The debt-to-equity ratio is a corporate finance ratio that measures how much total debt and financial liabilities a company has compared to the total shareholders equity. This is an important leverage ratio that a lot of investors, institutions, or shareholders will review before they decide to invest their own capital in a company.
As a result, with many financial ratios there isn’t a one size fits all approach to the debt-to-equity, or d/e. Understanding when and how to use it is important.
How Does Debt-to-Equity Work?
This ratio highlights how a company finances its operations. Calculating this equation is simple. The formula is D/E = total debt / shareholders equity.
For example, if a company has a debt-to-equity ratio of 0.75, it means the company uses $0.75 of debt financing for every $1 of equity financing. If the number was above 1.0, it would indicate the company uses more debt to finance their operations.
What Is Debt?
Debt is simply the amount of money a business has borrowed from a company or private lending source. Debt comes in all shapes and sizes, and usually has an interest expense associated with it as well.
Where Can I Find Debt?
Debt is found on the balance sheet under the total liabilities section. However, debt comes in all shapes and sizes and there are often numerous line items for the various debt a business has.
There are two main categories of debt, each category containing numerous subcategories.
- Short term debt – this is debt that needs to be repaid within 12 months
- Long term debt – this is debt that needs to be repaid within 12+ months
What Is Equity?
Equity in a business represents the ownership of the business and assets once all the debt is paid off.
Where Can I Find Equity?
To calculate equity, you must visit the balance sheet. In short, calculating equity is simple. All you have to do is add up all the company’s total assets and subtract all the total liabilities. Both the assets and liabilities are found on the balance sheet.
When Is the Debt-To-Equity Ratio Used?
This ratio is commonly used among stock investors. This formula highlights how much leverage a company is using. As a result, the higher the leverage ratio is, the riskier the investment would be considered.
How to Calculate the Debt-To-Equity Ratio for Companies
Any publicly traded company will have their financial statements available to the public. A great site to view publicly traded companies is www.finance.yahoo.com.
Remember, everything you need to calculate a company’s debt-to-equity ratio is found on the balance sheet. Divide the total debt (or total liabilities) by the total shareholders equity. That number is the debt-to-equity ratio.
You can compare that number to the company’s competitors. This is one data point worth reviewing and analyzing when you are thinking about what company you should invest in. Also note, many financial websites precalculate this number for you.
How Use the Debt-to-Equity Ratio For Personal Finances
You can also use the debt-to-equity ratio for your personal finances! Although your personal finances won’t have everything laid out on a balance sheet, you can easily calculate this ratio.
To figure out your personal debt-to-equity ratio, divide your total outstanding debt by your total assets.
Personal debt can include:
- Student loans
- Medical bills
- Owed taxes
- Credit card debt
- Car payments
Assets can include:
- Equity in a house
- Owning a car
- Owning a boat
If one has total debt of $150,000, and total assets of $100,000, their debt to equity ratio would be 1.5.
What Is a Good Debt-to-Equity Ratio?
Understanding how to land on the debt-to-equity ratio is only one piece of the puzzle. The second piece is analyzing the number. More importantly, the ratio between 1 – 2 is considered normal for most industries.
However, when you’re comparing this number, be sure to benchmark it against its competitors in the same industry. A technology company may have a different debt-to-equity ratio than a consumer goods company.
A high debt-to-equity ratio would be anything over 2. A high debt-to-equity number means the company finances its growth through debt. This can be a concern for investors if the debt levels get too high because all debt is eventually due.
A low debt-to-equity ratio indicates the company is able to finance their activities via shareholders. This is generally viewed as a good thing in the investment world, and the stocks/companies with a low debt-to-equity ratio are typically considered more stable investments when compared against stocks with a higher level.
A negative debt-to-equity ratio is concerning. When this ratio is negative it means that the company’s liabilities are more than the company’s assets.
Limitations of Debt-to-Equity Ratio
Despite how important this ratio is for fundamental analysis, it does come with some limitations:
- First and foremost, all debt is not created equal. The debt-to-equity ratio buckets all debt into one category, total liabilities. A company may have been able to secure some debt financing at a very low interest rate, which paints a completely different picture than debt secured at a high interest rate.
- The balance sheet represents the assets and liabilities at a specific point in time. For a company that purchases a lot of inventory, it’s accounts payable line item may be high if the company recently purchased a lot of inventory. Those payables may be due in 30/60/90+ days, and once paid off, the debt-to-equity ratio would change.
- Last but not least, the debt-to-equity ratio is specific to the industry. Some industries are very capital intensive and will require more debt financing. Whereas other companies may not need to borrow as much cash to finance their operations. Comparing the debt-to-equity ratio across a wide stock portfolio is challenging considering how diverse a portfolio can be. It is most useful to use this ratio when comparing similar companies, or competitors, in the same industry.
It’s One of Many
The debt-to-equity ratio is one of many fundamental financial ratios. In particular, this ratio highlights how a company finances their operating activities. Simply divide the total liabilities by the total shareholders equity to calculate the debt-to-equity ratio. All of the information you’ll need will be located on the balance sheet.
Interrupting the debt-to-equity ratio takes more knowledge. There are numerous variables that must be taken into consideration before any conclusions can be drawn.
Fundamental analysis can be overwhelming. If you’re questioning what stocks you should invest in, and what financial ratios you should review, consider working with a professional financial advisor. Financial advisors exist to help make sense of the investing world, and will help you invest in the right products that are aligned with you and your financial goals.