Debt to equity ratio formula and interpretation

The debt to equity ratio formula is an important metric used in corporate finance. The interpretation of the debt to equity ratio indicates if a company has enough shareholder equity to settle its debt should in case it faces a decrease in profits. This article will discuss the debt-to-equity formula, calculation, and interpretation. But first of what is it?

The D/E ratio evaluates a company’s financial leverage which is calculated by dividing the total liabilities of the company by its shareholder equity. In corporate finance, this ratio measures the extent to which a company is financing its operating activities through debt versus wholly owned funds. More particularly, the D/E ratio reflects the ability of shareholder equity to cover all outstanding debts in a scenario of a business downturn.

Investors use the debt-equity ratio to know the performance of a company in its capital structure as well as how solvent the company is. After an investor decides to invest in a firm, he/she needs to know the company’s approach. If the total liabilities of the firm is higher than the shareholders’ equity, the investor might have doubts about investing in the firm because having too much debt is too risky and can cripple the firm in the long run. However, if a firm balances its internal and external finance, the investor might feel the firm is ideal for investment.

Should a company face a decrease in its profits, the D/E ratio helps dictate if the company has enough shareholder equity to settle its debts. Notwithstanding, a firm’s debt-to-equity ratio varies at times because of various reasons such as the firm wanting to take advantage of timing its fund-raising so that it can minimize costs over the long run. The firm may also want to sell bonds when interest rates are low and sell common stock when prices are high. Another reason for the variation in the debt to equity ratio in firms at times is that the market allows some leeway in the debt-to-equity ratio before penalizing the firm with a higher cost of capital.

Therefore, due to the fact that risk varies when looking beyond the short term, investors tend to modify the ratio into long-term debt to equity ratio to focus on long-term debt or they use other formulas to dictate the short-term leverage of the firm. The debt-equity ratio tends to be greatly affected by changes in long-term debt and assets. Hence, investors can make use of other ratios to evaluate the short-term leverage of a company and its ability to settle debt obligations that are due over a year or less.

Debt to equity ratio interpretation

The debt to equity ratio interpretation shows a company’s debt relative to the value of its net assets. This ratio is mostly used to gauge the extent to which a company is taking on debt as a means of leveraging its assets. Therefore, lenders generally prefer a debt-to-equity ratio that is low. This is because a high debt to equity ratio is usually associated with high risk. It may be an indication that the company has been aggressively financing its growth with debt.

Nevertheless, the interpretation of whether the debt to equity ratio is high or low would depend on the industry in which the company operates. For instance, some industries like capital-intensive industries (e.g automobile manufacturers) tend to have a high debt-to-equity ratio whereas, industries that are not so capital intensive tend to have a low debt to equity ratio e.g personal computer companies.

Debt to equity ratio interpretation implies that a ratio greater than 1, shows that the majority of the company’s assets are financed through debt. While, a D/E ratio of less than 1, shows that the company’s assets are primarily financed through equity.

Furthermore, there is an average debt to equity ratio by industry which can be used as a yardstick. A company that has a higher ratio than its industry average, may find it difficult to secure additional funding from lenders or shareholders. Therefore, even though the debt-equity ratio varies from industry to industry, a ratio that is less than 2 is said to be a healthy debt-to-equity ratio. Such an ideal debt to equity ratio tells us that the company is a very low-debt business with a sound financial structure.

If a company uses lots of debt to finance its growth, it could potentially generate more earnings than it would have without that financing. This means that shareholders could expect benefits if leverage increases earnings by a greater amount than the debt’s cost (interest). However, if the cost of debt financing is far more than the increased income generated, there may be a decline in the value of the shares. Due to market conditions, the cost of debt can vary. Therefore, unprofitable borrowing may not be evident at first.

A business goal is not necessarily to have the lowest possible ratio. However, a very low debt-equity ratio could mean that the company is very mature and over the years, has accumulated a lot of money. It can also indicate a source of resource allocation that is not optimal. It is also likely that a very low D/E ratio may be a sign of overly prudent management that doesn’t seize growth opportunities.

Lenders and investors tend to favor businesses with lower debt to equity ratios because debt is inherently risky. A low D/E ratio will be seen as a lower risk of loan default to lenders and for shareholders, it would mean a decreased likelihood of bankruptcy in the event of an economic downturn.

A company applying a lot of debt to finance its increased operations results in a high debt to equity ratio. This could generate more earnings than it would normally have without this debt financing. The shareholders will benefit if the earnings increase by a greater amount than the cost of debt (interest) as more earnings are being spread among the same number of shareholders.

Conversely, if the cost of debt financing overshadows the return that the company makes on the debt through investment and business activities, bankruptcy may occur and shareholders would be left with nothing. In the banking and financial services sector, a relatively high debt-to-equity ratio is nothing out of the ordinary. This is because banks carry higher amounts of debt. They have a higher amount of debt because they own substantial fixed assets in the form of branch networks.

Apart from the banking and financial services sector, other industries like capital-intensive industries commonly show a relatively higher ratio such as the airline industry or large manufacturing companies. These industries utilize a high level of debt financing as a common practice.

Debt to equity ratio formula

The formula for debt to equity ratio is expressed as:

Debt to equity ratio= Total Liabilities/Total Shareholders’ Equity

• The total liabilities in the debt to equity ratio formula include both current (short-term) and long-term liabilities.
• The total shareholders’ equity in the formula for debt to equity ratio is calculated as total assets – total liabilities.

Modifications to the debt-to-equity ratio formula

In the balance sheet, the shareholders’ equity portion is equal to the total value of assets minus liabilities. However, this is not the same thing as the assets minus the debt associated with the assets. Hence, a common approach to resolve this issue is to modify the formula for debt to equity ratio into the long-term debt to equity ratio formula. An approach like this enables the analyst to center on important risks.

The concept of this is that even though the short-term debt is part of the overall leverage of a company, these short-term liabilities will be paid off in a year or less, thus, they are not as risky. Take, for instance, we are comparing Company ABC with $500,000 in short-term payables and $1 million in long-term debt, to Company XYZ with $1 million in short-term payables and $500,000 in long-term debt. Now, if these two companies have $1.5 million in shareholder equity, then they will both have a debt-equity ratio of 1. The risk from leverage seems the same when you look at it on the surface, but in reality, Company ABC is riskier.

As a rule, short-term debt tends to be cheaper compared to long-term debt. It is less sensitive to shifting interest rates, thus, Company ABC’s interest expense and cost of capital are higher. So when interest rates fall, long-term debt will need to be refinanced, which can later increase costs. Therefore, interest rates that are on the rise would appear to favor the company with more long-term debt. However, it could still be a disadvantage if the debt can be redeemed by bondholders.

Debt to equity calculation

How to find debt to equity ratio is to divide the total liabilities of the company by its shareholder equity. The information needed for the debt to equity ratio calculation is on a company’s balance sheet. The balance sheet requires total shareholder equity to equal assets minus liabilities.

However, these balance sheet categories may consist of individual accounts that would not ordinarily be thought of as debt or equity in the traditional sense of the book value of an asset or a loan. Therefore, further research is often needed to understand a company’s true leverage being that the debt/equity ratio formula can be distorted by intangible assets, pension plan adjustments, and retained earnings/losses.

Analysts and investors will usually modify the D/E ratio formula due to the ambiguity of some of the accounts in the primary balance sheet categories. They modify the ratio to be more useful and easier to compare between different stocks. Calculation and analysis using the debt-to-equity ratio formula can also be improved by including profit performance, growth expectations, and short-term leverage ratios.

Here are some examples of how to calculate debt equity ratio:

Example 1: How to calculate debt to equity ratio from balance sheet

Using the exert from Apple balance sheet for the fiscal year of 2020 below, let’s calculate the D/E ratio of Apple.

From the expert of Apple, Inc. (AAPL) 2020 balance sheet above, we can see that for the fiscal year (FY) ended September 26, 2020, Apple had total liabilities of $258,549,000,000 and total shareholders’ equity of $65,339,000,000.

Solution

How to calculate debt to equity ratio from a balance sheet

Using the debt to equity ratio formula:

Debt to equity ratio= Total Liabilities / Total Shareholders’ Equity

Calculating debt to equity ratio will be:

D/E ratio = $258,549,000,000 / $65,339,000,000 = 3.957

This means that Apple had $3.96 of debt for every dollar of equity. The debt to equity ratio of Apple seems to be high because it is a capital-intensive company. Banks, financial firms, and capital-intensive companies such as airline companies or large manufacturing companies commonly show a relatively higher D/E ratio because they utilize a high level of debt financing as a common practice.

How to calculate debt to equity ratio example 2

Calculate the debt-equity ratio of Company XYZ assuming it has the following information:

• Current Liabilities – $53,000
• Non-current Liabilities – $120,000
• Common Stocks – 25,000 shares of $30 each
• Preferred Stocks – $150,000

Solution

Using the debt to equity ratio equation:

Debt to equity ratio= Total Liabilities / Total Shareholders’ Equity

How to find the debt to equity ratio of company XYZ is to first calculate the total liabilities and total shareholders’ equity:

Total liabilities= (Current liabilities + Non-current liabilities)= ($53,000 + $120,000) = $173,000

Total shareholders’ equity= (Common stocks + Preferred stocks)= (25,000 × $30) + $150,000= $900,000

We will then calculate debt to equity ratio as:

D/E ratio = $173,000 / $900,000 = 0.19

This means that Company XYZ has a very low debt-to-equity ratio and could mean that the company’s assets are primarily financed through equity.

Limitations of the debt to equity ratio formula

There are some limitations to the debt-to-equity ratio. It is crucial to consider the industry that the company belongs to when using the debt-equity ratio. The reason is that different industries have different capital needs and growth rates. For instance, a relatively high debt-equity ratio may be common in one industry, whereas a relatively low debt-equity ratio may be common in another industry.

Utility stocks, for example usually have a very high debt to equity ratio compared to the market averages. Utility stocks grow slowly but are normally able to maintain a steady income stream. This allows the companies to borrow very cheaply. Therefore, a high leverage ratio in slow-growth industries that have stable income indicates an efficient use of capital. Companies in the consumer staples or consumer non-cyclical sector also tend to have a high D/E ratio.

Another drawback with the D/E ratio is that analysts are not always consistent with what is considered ‘debt‘. For instance, sometimes preferred stocks are considered equity, meanwhile, preferred dividends, par value, and liquidation rights make these stocks look more like debt. Therefore, the D/E ratio will increase when including preferred stock in total debt, thus, making the company look riskier. On the flip side, including preferred stock in the equity portion of the ratio will increase the denominator of the debt to equity ratio formula and lower the D/E ratio. Including preferred stocks in the D/E ratio can be a big issue for companies such as real estate investment trusts (REITs).

FAQs on debt-to-equity ratio