Debt-to-Equity (D/E) Ratio – Formula, Calculation and Interpretation
What is Debt-to-Equity Ratio?
The debt-to-equity ratio (D/E ratio) is a financial metric that compares a company’s total debt to its total equity. It is calculated by dividing a company’s total liabilities (including both short-term and long-term debt) by its total shareholder equity. The resulting ratio indicates the proportion of a company’s funding that comes from debt as compared to equity.
What is the Meaning of Debt and Equity ?
To understand the debt-to-equity ratio, let’s first understand the terms- equity and debt:
Equity
Equity is the net worth of the company. It is the value that shareholders would receive after a company liquidates its assets and pays off its liabilities. Equity is the permanent capital an owner or shareholder holds at the end.
Equity is classified into book value and market value. The book value of equity is calculated as the difference between assets and liabilities and entered into the company’s balance sheets. Market value is an estimation of the current share prices.
Debt
Unlike equity, debt refers to the capital or funds that a company owes to others. These are obligations for a business to meet within a given time. A business has to pay off its debt along with interest against the amount.
Debt is of three types: term loans, debentures and bonds. Term loans are taken from banks while bonds and debentures are issued to the general public.
The debt value is subtracted from a company’s asset value to understand its net worth. These two factors are beneficial in judging an organisation’s financial performance. To make the understanding convenient, equity and debt are represented in ratios like 1:1, 1:2, 2:1, 2:2 etc. The debt-to-equity ratio gives an idea to investors whether a company easily meets its debt obligations or is on its way to bankruptcy.
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Debt-to-Equity Ratio – Types of Debt
A D/E ratio can include some or all of the following types of debt:
1. Long-term Debt
This is debt that is due to be repaid over a period of more than one year. Examples of long-term debt include mortgages, bonds, and long-term loans.
2. Short-term Debt
This is debt that is due to be repaid within one year or less. Examples of short-term debt include credit card balances, accounts payable, and short-term loans.
3. Leases
Leases can be considered a form of debt because they represent an obligation to make regular payments over a period of time. Operating leases are not typically included in the debt-to-equity ratio calculation, but capital leases are.
4. Other Liabilities
This can include a wide variety of other obligations that a company has, such as deferred revenue, pension liabilities, and taxes payable.
How to Read the Debt-to-Equity Ratio?
One can find the debt to equity (D/E) ratio on the company’s balance sheet.
The debt-to-equity ratio of any company is shown as-
D/E Ratio = Total debt of a company / Shareholders’ equity.
Let’s assume that Company A’s debt-to-equity ratio is 1:2. This implies that the debt the company owes to banks or other organisations (numerator) is less than its total equity (denominator).
One would expect the ideal debt/equity ratio to be 1:1, showing stable financial functioning. However, there may be changes in the ratio due to the volatile nature of the market. Many analysts consider a DE ratio of 2:1 to be ideal, but this can vary across industries.
Debt-to-Equity Ratio Formula and Calculation
Debt to Equity Ratio Formula
- Debt to equity ratio = Total debt of the company/shareholders’ equity
- Total debt = short-term borrowings + long-term borrowings + fixed payment obligations
Shareholders’ equity is the net assets a company owns.
Example:
The total liabilities of Company A are Rs. 60 crore while its total shareholders’ equity is Rs.30 crore.
The debt to equity ratio of Company A stands to be (60 crore / 30 crore) 2:1
This means the company has more debts to pay than its net assets.
Debt to Equity Ratio Calculation
Calculated debt to equity ratio by dividing a company’s total debt by its total shareholder equity.
Here’s how to calculate the D/E ratio:
D/E Ratio = Total Debt / Total Shareholder Equity
Total debt includes all of a company’s short-term and long-term debt obligations, including loans, bonds, and other forms of borrowing. Total shareholder equity includes all of a company’s equity investments, including common stock, preferred stock, and retained earnings.
To calculate the D/E ratio, you can use the following steps:
- Find the total debt on the company’s balance sheet. This information can be found under the liabilities section of the balance sheet.
- Find the total shareholder equity on the company’s balance sheet. This information can be found under the equity section of the balance sheet.
- Divide the total debt by the total shareholder equity. The resulting number is the D/E ratio.
How to Calculate D/E in Excel
To calculate the Debt-to-Equity (D/E) ratio in Excel, you will need to follow these steps:
- Open a new Excel spreadsheet and create two columns: one for Debt and another for Equity.
- Enter the amounts of total Debt and Equity for the company in the corresponding columns.
- Calculate the D/E ratio by dividing the Debt by Equity.
- The formula is: = Debt / Equity
- Type the formula into a cell where you want the D/E ratio to appear. For example, if the Debt is in cell A1 and the Equity is in cell A2, you would enter:
- =A1/A2
- Press Enter to calculate the D/E ratio. The result will appear in the cell where you entered the formula.
- Format the cell as a percentage if desired. Right-click on the cell and select “Format Cells.” In the Format Cells dialog box, select “Percentage” under the “Number” tab.
- Save your spreadsheet by clicking “File” > “Save” or pressing Ctrl + S.
That’s it! You have successfully calculated the D/E ratio in Excel.
Benefits of a High Debt-to-Equity Ratio
When a company’s debt to capital is above 1 (ratios 2:1 and above), it is a high D/E ratio. A high DE ratio can be good and harmful for a company.
Here are a few benefits of a high D/E ratio:
- A business can receive a high Return on Equity (ROE) as its assets increase and its equities decrease.
- When the cost of debt is lower than the cost of equity, a higher debt ratio can be beneficial. This lowers the weighted average cost of capital (WACC).
- Owners can retain control, and the company can leverage the increased cash flow to increase its returns.
Drawbacks of a High Debt-to-Equity Ratio
Having a high DE ratio can also be a setback to a company. Below are some of these disadvantages:
- A high D/E ratio results in a higher risk factor for investors who may have second thoughts about investing their hard-earned money.
- The owner has to be careful before borrowing more funds as a high DE ratio means delayed repayments.
- When the WACC of a company goes extremely high, its share prices tend to drop.
How to Interpret the Debt-to-Equity Ratio?
The following is an interpretation of different DE ratios:
- When the ratio is 1:1, the company has a stable flow of equity and debts. Here, its liabilities are timely met, and there is no shortage of assets
- When this ratio stands less than 1 (1:2, 1:5 etc.), the company has few debts. These are manageable with ample net assets present
- The DE ratio of 2 and above is considered a too high number. Here, the debt is more than the assets. If not timely met, it can lead a company to bankruptcy
What is a Good Debt-to-Equity Ratio?
In simple terms, a good debt-to-equity ratio is a debt the company can easily pay is “good” debt. Numerically, ratios below 1 are good debt-equity ratios.
Shares of companies with good D/E ratios are favourable for investors. They have a lesser risk of going down soon than companies with bad D/E ratios.
What Is a Bad Debt to Equity Ratio?
When a company cannot meet its interest and debt payments for various reasons like a drop in sales or fewer workforces, its D/E ratio rises.
Debt to equity ratio of 2 or above is considered a bad D/E ratio. Such companies carry high risks for investors. Although the share prices of these companies are usually low, they have a looming fear of bankruptcy.
DE ratios between 5 and 7 are a very high-risk zone for companies.
What industries have high D/E Ratios?
- Utility Companies – These companies require significant capital expenditures to build infrastructure, and as a result, they often have high levels of debt.
- Real Estate – Real estate companies often have high levels of debt to finance property acquisitions and development.
- Energy – Energy companies, such as oil and gas exploration and production companies, often require large amounts of capital to fund exploration and production activities.
- Telecom – Telecommunication companies require significant investment in infrastructure and technology to maintain and expand their networks.
- Transportation – Transportation companies, including airlines and shipping companies, require significant capital expenditures to acquire and maintain their fleets.
- Finance Company – Finance companies, such as banks, credit unions, and insurance companies, often borrow large amounts of money to finance their operations and investments, and this can result in higher levels of debt relative to equity.
How can D/E ratio be used to measure a company’s riskiness?
The Debt-to-Equity (D/E) ratio is a financial metric that compares a company’s total liabilities (debt) to its shareholder equity. This ratio is often used as a measure of a company’s financial leverage, or the extent to which it is using borrowed funds to finance its operations. A high D/E ratio can indicate that a company is relying heavily on debt to finance its operations, which can increase its financial risk.
Here are some ways in which the D/E ratio can be used to measure a company’s riskiness:
1. Bankruptcy Risk
A company with a high D/E ratio is generally considered to be at greater risk of bankruptcy, as it may struggle to meet its debt obligations if it experiences a downturn in its business or faces higher interest rates.
2. Operational Risk
A high D/E ratio can also indicate that a company is taking on more risk in its operations, such as investing in risky projects or acquiring companies with high levels of debt. This can increase the risk of financial losses if these investments do not generate expected returns.
3. Return on Equity
A high D/E ratio may also reduce a company’s return on equity (ROE), as more of the company’s profits must go towards servicing its debt obligations rather than being reinvested in the business or paid out as dividends.
What is Long-Term Debt to Equity Ratio?
The long-term debt-to-equity ratio dictates the leverage of a company. To calculate this ratio, one has to divide a company’s long-term liabilities by its equity.
The company’s leverage is directly proportional to its long-term D/E ratio. Companies with higher long-term D/E are risky investments. Yet, they can generate more growth.
Long-term D/E ratios are not ideal for short-term investors to consider.
Final Word
A company needs to have manageable levels of debt and equity. Those that borrow innumerable debts might fall short of assets to pay them up. There is no doubt that slightly high debt-to-equity ratio has some benefits. However, if it gets too huge, paying debts in time can be a challenge.
For an investor, a high DE ratio is an opportunity only when they are willing to invest long-term. Those who are new to the trading game will want to make a well-researched decision before investing.
FAQs
The D/E ratio of a company decreases when shareholders receive their dividends. Though dividends are not a part of equity, paying cash to shareholders reduces their equity as a company pays them from its earnings.
The ideal debt to equity ratio depends on the industry and a company’s repayment capacity. Many analysts consider a DE ratio of 2:1 to be ideal as it is manageable. For other industries, this can vary from 2 to 2.5.
The D/E ratio reflects the financial health of any company. A high D/E ratio implies that the company has high levels of debt. If not taken care of, the company may go bankrupt. Investing in such companies can be a risk of losing money to investors.
When a company has more liabilities than assets, its D/E ratio is negative. These companies carry a high risk of bankruptcy, resulting in most investors avoiding them.
The formula of calculating long-term debt-to-capital ratio is:
Long-term D/E ratio = Long-term debt / Shareholders’ equity.
The Debt-to-Asset (D/A) ratio is a financial ratio that measures the percentage of a company’s total assets that are financed by debt. It is calculated by dividing a company’s total debt by its total assets.
Disclaimer
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
